Invest Like the Best with Patrick O'Shaughnessy
· Alan Waxman, Patrick O'Shaughnessy
That's a pretty good system – until we started to see behavioral changes in 2018. [00:00:00] S0: Just to put a pin on an elegant well-designed system of guardrails and incentives. The commercial model where it's lower risk and protected or backstopped and higher risk-seeking capital where the assets and liabilities are matched is a good system. [00:00:00] S1: It's a good system. All crises generally are caused from not credit issues or others. They might start in other issues, but it's mismatched assets and liabilities. [00:00:00] S0: So you mentioned the year 2018 as being a pivotal point. I want to explain that transition, but it feels important. You and I have talked about this notion of yours of the factory model before. We're going to go into that in more detail, but just to plant the seed in people's mind, define the factory model just briefly, and then I want to talk about what happened to get us transitioned and the incentives towards that model.
· Alan Waxman
[00:00:00] S1: So the way that we define the factory model in our industry is there's two parts to it and then there's an output. First part is the industrialization of the fundraising process. Say liability gathering. Literally raising as much capital as you possibly can, as fast as you can. So that's the industrialization of the liability side of the fundraising side. That comes first. And then what comes second is then, as a result of that, the industrialization of the asset side. So think about investing. If you're on an investment team and all of a sudden your firm has a lot of money to invest, and it's just sitting there and maybe there's a timestamp on it. All of a sudden your behavior has to start to change, because you have to deploy that money much quicker. And what's the best way to raise a lot of capital quickly? Make it very simple. Make it very narrow, because if it's wide, that's too hard to explain. So you want to make it as narrow as possible and you're also willing to take – let's say, make concessions on the type of capital you raise. Meaning maybe it's got a term where they can ask for your money back. So instead of perfectly matched assets and liabilities, maybe you're willing to start to not have perfectly matched assets and liabilities because you want to raise it as fast as possible. And again, when people hear this, they're going to think I'm only talking about the bigger firms in our industry, but it filtered down to mid-sized firms, smaller firms for a whole bunch of reasons, but this whole factory model behavior started to reveal itself in 2018.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: The visual that's coming to mind on the asset side, and again, we'll come back to both these ideas in more detail. But I think of an artisan making a horse saddle or something by hand ,and then I get an order for 100,000 horse saddles. I can't make it by hand. I've got to make a factory. [00:00:00] S1: That is the exact way to think about it because it's a different model when you're building that horse saddle, versus you get a massive order. But one point that's important is that it starts always on the liability side, and then it goes to the asset side, and then you get the current moment that we're in that I know we're going to talk about. [00:00:00] S0: It starts on the liability side because why? [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.
· 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.