Invest Like the Best with Patrick O'Shaughnessy
· 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.
· 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.