Invest Like the Best with Patrick O'Shaughnessy
· Alan Waxman, Patrick O'Shaughnessy
[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. [00:00:00] S0: And is maybe the crass way to say this, in the factory model, the GP, the founder of the firm, stands to make a lot more money from the equity of their GP than from the carry they would earn through investing, or something like this.
· Alan Waxman
[00:00:00] S1: What I'd say is that – look, to be a CEO of one of these larger – it's hard. You have a lot of different constituents. It's really hard. As an investment firm, sometimes it's good to grow, and sometimes it's not good to grow. It depends on what's the investment environment, what's the quality of your liability structure, what's the flexibility of your investment model to migrate to where the best opportunities are. It just depends, but I think it boils down to what's your clarity of purpose. There are a number of people that are public that I would say have not adopted a factory model. There are a number of people that are not public that have adopted a factory model, maybe because they want to get bought by one of the larger guys, or maybe if you're a mid-sized firm and you want to be one of them. The issue is, just because you're large and just because you're public, it doesn't mean that you've adopted the factory model. It's like, what is your clarity of purpose? Now, if your clarity of purpose is to be an investment bank, then maybe that is what you want to be, a factory model. But if you're going to do it, you better have really good risk management. That's why, if you look at commercial banks, Jamie Dimon is probably one of the best risk managers of all time. What he can do from a risk management perspective, and you saw in GFC, and you've seen in other times in his career – he's a better risk manager, but the rest of the industry that follows suit because they want to be Jamie Dimon, they might not be as good of risk managers as him. And it's the same thing over here. So it's not just the larger guys, because remember, the industry always follows the larger guys, but it's not certain that just because you're public, just because you're large, that you've actually adopted the factory model.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: What are the most common, in your mind, telltale signs of a firm that's in this model? What is a firm that's adopted the factory model look like that's distinct from an investment model-based firm? [00:00:00] S1: First of all, you know when you see it. You can see it in the underwriting. We're in a bunch of different asset classes. You can see it, particularly if you're a fixed income investor or credit investor because you have capped upside. There's terms you just don't give. A lot of those terms have been given. [00:00:00] S0: To facilitate deployment of capital. [00:00:00] S1: You should not do those terms, because it's all good when you're in a procyclical environment. But if you have capped upside and you're earning a 10% return and all the collateral that your 10% is based on can literally be taken out of your collateral package overnight. Or for that 10% return, you can be levered up because let's say there's an AI disruption and some software company needs to reposition their business and they can basically lever you up. So you go from 50% loan to value to 120% loan to value. Those are just things that you shouldn't do for a 10% return.
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: You should not do those terms, because it's all good when you're in a procyclical environment. But if you have capped upside and you're earning a 10% return and all the collateral that your 10% is based on can literally be taken out of your collateral package overnight. Or for that 10% return, you can be levered up because let's say there's an AI disruption and some software company needs to reposition their business and they can basically lever you up. So you go from 50% loan to value to 120% loan to value. Those are just things that you shouldn't do for a 10% return. [00:00:00] S0: The first time we did this, we talked a lot about return per unit of risk. It basically sounds like the thing happening in the factory model is that that has fallen out of whack. The objective function becomes more deployment of capital because that ties to size of my business, multiple on the business, how much money I'm making as a shareholder or whatever. And it's fundamentally divorced from the investing equation, which is return units per unit of risk or something like that. So map this on to the news cycle today. What is happening? Where are there asset-liability mismatches? What are the nature of them? What's the implications?
· Alan Waxman
[00:00:00] S1: Again, go back post-COVID, that's when the wealth space took off. So the democratization of alternatives or private capital, which just to be clear, not against that. Some of the factory models that are out there have raised capital from the wealth channel in irresponsible ways. So first of all, in general, you're taking an illiquid asset and you're giving investors an ability to get their money back quarterly. They say semi-liquid. There's no semi-liquid, okay, there's no such thing as semi-liquid. Anyone that's an investor that's been through a bunch of cycles – there's liquid, and then there's illiquid. Because again, going back to the history of the wealth channel or individuals or retail, the one thing we know, it's very procyclical. We're in a procyclical environment. It's easy to raise money. And when you're not, and when there's problems or dislocation like there is today, they want their money back. So you basically had mismatching of illiquid assets and liabilities. So that's one part of it. The second thing is that they would raise these very narrow – what I mean by narrow is it's just direct lending. So it's not like you can invest in direct lending and real estate and infrastructure or in asset-based finance. No, no, it's just very narrow. Just direct lending or just asset-based finance or just this strategy. That's a narrow strategy. And maybe that's okay if you raise the right amount of capital. But if you raise an unlimited amount of capital where your investing is dictated, not on good investments in the market, but basically dictated by how much money you can raise. There's never a governor on how much money to raise. And the thing about these wealth vehicles, when they raise it, they have to invest it right away. We call it inflow investing. They have to invest it right away. So they raise as much money as they can, and if they don't invest it right away, it dilutes the return of that vehicle.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: To ground this in actual reality as much as possible. We've talked about all these guardrails, all these incentives, the three problems. All this stuff where the system structure begins to determine fate. What is fate? What is actually happening today? [00:00:00] S1: What's happening today is there are these vehicles called perpetual private BDCs. These have been raised in the wealth channel. So individuals, wealthy, mass affluent, they've been raised. And again, in some cases, not all cases, in very narrow strategies. So just direct lending or just private equity. And really the catalyst was software and AI. And also some of the market volatility, but starting to question the quality of their portfolio. Or it could have just been market volatility because of what's going on outside of this where people want their money back. There's a limit on how much money people can ask for. And basically, in the perpetual private BDC space, the amount of money people have asked for has exceeded what is the 5% limit. And that's creating all the noise that you're reading about. [00:00:00] S0: What's the range of so what's here? I can imagine one so what is like, "Tough shit, you can't have your money back," and the world keeps spinning. Another is something dangerous and scary and systemic because past financial crises have tended to be downstream of some domino, like private BDCs or whatever it is. Each time it's different. What do you think the range of implications of all this is?