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- [00:00]
A
Well, hello capital Decanters. As we take a short break and a needed rest between season two and three, we're doing something a little bit different this year to highlight our key episodes. So given the sequence and the timing of when these episodes are released, as we thought more about it, because they drop across a period of 10 months almost, it's a bit unfair to simply take the quantitative number of downloads as that of course is going to arbitrarily advantage the first few episodes that have been available, of course, the longest. So this year we're going to combine a little bit of art and a little bit of science to highlight what we're calling the decanted half dozen. These are the six episodes that were the most influential and popular. And that's based of course on the pure stats, but also on what we're hearing around the industry about what topics are most timely and transformative. So here they are, season two's most influential and popular episodes. Coming in at number three of the Decanters half dozen for season two was episode five, the Modern Asset Owner. The asset owner role has metamorphosized in recent years to one of just identifying and partnering with gps, to employing a much more sophisticated tool set, including direct and co invest secondaries, joint ventures, GP seating, and much more. We actually called it a cockpit in the episode. So how is the top of the food chain reshaping how portfolios are constructed? Welcome to Capital Decanted. In this show, we say goodbye to tired market takes and superficial sound bites because here, instead of skimming the surface, we dive into the heart of capital allocation, striking the perfect balance and exposing the subtleties that reveal the topic's true essence. Prepare to have your perspectives challenged as we open up the issues that resonate with the hearts and minds of those shaping capital allocation. We've enlisted the wisdom of visionary leaders in the industry and just like a meticulously crafted wine, allow their insights to breathe, unfurling their hidden depths and transforming our understanding. This is season two, episode five of Capital Decanted, the modern asset owner. I'm John Bowman. And I'm Aaron Filbeck and we are your hosts. Couple programming notes, just a huge thank you as always to our returning title sponsor, Alternatives by Franklin Templeton. We're obviously so grateful they're back to partner with us for this second season. They've got over 40 years of alt investing and over 260 billion of assets under management. Their specialist investment managers have expertise across six different asset classes. Real estate, private equity, private credit, hedge strategies, venture capital and digital assets. And of course all of them operate with the client first mentality that has always defined Franklin Templeton to help prioritize investment outcomes. So thanks as always to alternatives by Franklin Templeton and we are just delighted to introduce a brand new episode sponsor, SLR Capital Partners. SLR is an independent boutique asset manager focused on direct lending with expertise across a range of primarily senior secured financing solutions for US Middle market companies. They have roots as a cash flow direct lender to sponsor owned companies and this new SLR platform has evolved and expanded into a diversified commercial finance solutions provider encompassing cash flow, asset based lending and specialty to finance and we're going to hear more from SLR co founder and co CEO Michael Gross at halftime today. So stay tuned for that. So Aaron, we spent a lot of this show, not just this season but both seasons on what I would call the transformative nature of this business. That's of course what you do when you decant, you ponder you big things. But quite seriously, As I wrote in a recent letter to our membership, innovation has always been a hallmark of investment management. But what I wrote was that the pace of disruption, in my view today, is unsurpassed. It has sped up. That flywheel is spinning as quickly as we've ever seen it, and that disruption has reached the shores of the asset owner. The top of the food chain, you might say. And so whether you work for a gp, a consultant, an investment bank, a traditional asset manager or some other supporting actor within this larger ecosystem, if you don't understand the hearts, minds and processes of the ultimate client, the asset owner, you're going to be at a disadvantage. So I think this is a really important moment in the evolution of the business for us to take stock of what asset owners are doing so today is meant to provide a glimpse in the rapid and radical shift we've seen in what I would call the behavior, the philosophy and the toolkit of the asset owner and all the downstream effects that are inevitable as a result. Today allocators no longer sit cleanly or purely in the endowment or the Canadian model camp, meaning on the one hand relying solely on external GPS or on the other, insourcing most of the investment process. Nor is it particularly helpful to talk about today's methods and approaches as just a linear extrapolation or next phase of either of those models. As we'll talk about in depth, this is a brand new dimension and mindset that asset owners are adopting that adds more flexibility, sophistication, complexity, and most importantly, I would argue, control and as I'll tease out later, I liken it to transitioning from a single slider knob of in source outsource to sitting in a next generation cockpit surrounded by instrumentation. It is just an explosion of different opportunities. So here's what Aaron and I plan to do. I'm going to start, as is typical here at Capital, decanted with a bit of context and background. Where did the Endowment and Canadian models come from? What is their essence? And maybe most importantly, beyond the mythology associated with these paradigms, what were they originally intended to solve for? And I'm going to hope to use that background to attempt to justify why the modern asset owner has weighed and measured these models in today's environment and found them wanting and in need of an upgrade. And then before handing to Aaron, I'm going to briefly introduce a new archetype, a new model that we are generically calling the Collaborative model and all of its facets and components. Aaron's going to then break down some of those very components in more detail for us so we can better understand the buffet table or the tool belt that now is being employed by today's cio. Again, imagine that cockpit. And then finally after the halftime break, we'll invite two CIOs into studio that really are exemplars in implementing cutting edge thinking and breakthroughs in their plans towards this more collaborative model. And those CIOs are Molly Murphy, CIO of the 25 billion Orange County Employment Retirement System or OSERS, and Scott Chan, CIO of the largest teachers pension in the world, the second largest public pension in the states, $350 billion CalSTRS. So that's where we're going. So Aaron, I want to pose a question to you first as we dive into history and that is who invented the Endowment Model?
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B
That's a great question, John. Well, I know that David Swensen popularized this, but I think the history of the Endowment Model goes even further back into history. So I'll do the cop out and say David Swensen made it famous, but there's probably a better answer and I'll pass it back to you.
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A
That's the answer I expected. And listeners, we don't script this at all. So Aaron did not know that was coming. I think most would say just what you said, David Swensen, but I think your word of popularize is an important one. I'm going to come back to in a moment. So David Swensen, one of the true goats of investment management, as I'm sure all of you know, he was the CIO of his alma mater, Yale for 36 years until his sadly much too early death about three years ago in 2021. In fact, most will use the Endowment model interchangeably with the Yale model, as the Endowment model was, at minimum, to use your word, popularized or socialized and came of age under David Swensen. But I think maybe a different question is if David were sitting with us here today, who would he say invented the Endowment model? So to answer that question, if you read Pioneering Portfolio Management, which is of course his seminal work that effectively lays out his investment philosophy and probably is the best summary of the Endowment model as we call it, he makes pretty clear where he was inspired. But let me just say this first, I'm going to keep you in suspense a little bit longer, a little bit of definitional level setting. The Endowment model has taken on many shapes, sizes and flavors, as I mentioned, mythology in the opening. So there's a ton of apocryphal information out there, meaning beyond the canon of its birth story. There's a lot of stuff that's attached itself to this methodology. But really the Endowment model, at least its initial intention, was very simple. The Endowment model is grounded in the belief, frankly, that the portfolio should have an equity orientation. Now, let's just pause here, as you have to remember that before the age of the Endowment model, and again, I'm going to talk about that moment in a few seconds, most institutional capital was largely fixed income. And the Endowment model stared down the common wisdom of the time and argued that a heavy equity exposure ultimately had a better risk reward profile for compounding capital. And again, I want to stress this. This would have been viewed as reckless casino talk in most circles at the time. It's hard for us to grasp how much of a departure this was. If you travel at all or read any of the popular investment press, you'll often hear today's endowments, particularly the Ivy Leagues and the other larger ones, as what's called the smart money gps will tell you that they are the Most sought after LPs because of their sophistication and their long term partnership and their patience. But they were certainly not the smart money in the 70s and 80s. So the transition here was stark. The idea of an equity orientation would have been shocking. And it started with this idea of the merit of shifting towards equity risk premia. And that increased equity exposure manifested certainly itself in other pillars of what would come to define the Endowment model. As so many university investment offices professionalize in the coming decades. Using this blueprint and those pillars, of course, would include broad diversification across asset classes, particularly a heavy allocation to privates, avoidance of fruitless attempts at market timing, mostly often exclusive use of external gps, and then vigilance around what I'd call long term orientation, which allows for you to be really bold and countercyclical in some of your investing decisions. So with that context, Aaron rewinding to the answer to the question, Swensen's inspiration that he makes reference to in his work back in 1921 until his death in 1946, a gentleman that was CIO of King's College was his inspiration. Any idea who that was?
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B
I don't, no.
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A
Well, John Maynard Keynes, which is a name you will certainly recognize from macroeconomics.
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B
I do, yes, certainly, yes.
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A
Now, when Keynes took over the endowment, most people don't know Keynes was actually a CIO before he became the economic icon. But the portfolio that he inherited at King's College was largely real estate and it consisted of property, real property and buildings in and around the Cambridge based university and a heavy allocation to fixed income. And Keynes would go on to transform that portfolio to an allocation that was heavily reliant on equities. And Swensen made a study of his process and writings along the way. In fact, Swensen wrote of Keynes in his book, quote, as a result of his experiences and his advocacy for equities as the preferred asset class for long term investors, the great economist had a considerable influence on the US Endowment model. So Keynes himself is possibly the first true endowment model cio. But I want to give you one more alternative origin story, because history is always a mosaic of a whole lot of moving parts and moments in time and intersections of fate. But in the late 60s, so this is two decades after the death of Keynes. As we talked about in the regulatory episode last season, investment returns of college endowments were pedestrian at the time. Again, think all fixed income. They're unable to preserve principal, much less to produce sufficient returns to support the university operating budget. And some of the demands coming from the purpose of the corpus. And so despite Keynes success in England, these funds remain largely, as I said, in fixed income and cash instruments. And therefore they, they were hampered by a low return environment. And if you know your history a little bit, we were just starting to experience some rising inflationary pressure as we approached the 70s. And this lag caused increasing concern throughout the higher education industry, I might even say somewhat dramatically an existential crisis of how colleges and universities were going to survive based upon their endowments not supporting the budgets. And so to dive deeper into this subject in the moment of this crisis, the Ford foundation, the grant making private foundation set up by Edsel Henry Ford's daughter, sponsored a seminal study called I love this report title the Law and the Lore of Endowment Funds that explored better ways to achieve what they called a more attractive total return. So as a result of this Ford foundation study, in 1971 they Ford foundation awarded a $2.8 million grant to found the Common Fund for Nonprofit organizations, or Common Fund as we know it today and is one of the largest and most reput independent o C I OS that we have. And we mentioned this history in episode eight of last year, by the way, which was dedicated to the formation and the future of the outsourced CIO model. And Mark Anson, current CEO and CIO of the Common Fund, was one of our guests. So I would commend that one to you for a little bit more color on the history. So that is the Endowment model. So I want you to park that for a moment because as I mentioned, there's a parallel development story with the Canadian model that intersects here provides another color for our discussion today. 1987, so much more recently, then treasurer of Ontario in Canada, Robert Nixon was his name, made somewhat of an infamous speech in which he declared that the public sector pension management in Ontario was broken, was immature, and then they needed a much better mousetrap. And so he gathered a cabal that included the president of the Ontario Teachers Federation, which at the time was a woman named Margaret Wilson, and pension luminary, an institutional investing thought leader many of you might recognize. Keith Ambek Shear to produce a 400 page report. Imagine reading that one outlining a more optimal approach to build an autonomous, well functioning pension system that was built for purpose. And this report ultimately led to the passage of the Pension management Act of 1990. And this act basically created the legal framework for a new pension organization. The legal structure, the purpose, the board, oversight, et cetera. And Ontario teachers was created shortly after the pension act. And CPP investments followed in 1999, several years later. And so we were off to the races in the late 90s and launching what ultimately what we now all call the Canadian Model. So what exactly is the Canadian Model, or the Maple Model as it's sometimes called? Again, as with the Endowment model, sometimes the lore, to borrow the Ford Foundation's word, replaces true history. And some of the secondary items, or the results can absorb the true essence. So back when those founders imagined their better mousetrap, they made the case that these pensions need not just be allocators of capital, but actually world class organizations. So what do I mean by that? Well, it places much more emphasis on not just investing capability, but also building competency across the full set of systems and technology and talent. And the Canadian model even today is about cultivating a durable culture that promotes innovation, repeatable and defensible processes, and a robust operational and risk infrastructure. And importantly, it's overseen by an independent board of fiduciaries, free from conflict, removed from political agendas, and simply focused on maximizing outcomes for beneficiaries. So it's about the entire system and fund being positioned for generational success and continuity of purpose, you might say. And shorthand for all of this is insourcing. Unlike the lean and hyper focused teams in an endowment model that really rely on partners, GPs, consultants and vendors for most anything outside of manager selection and due diligence, the Canadians have brought all those capabilities in house as they really feel it enables the investment teams to deliver outsized returns over the long term. Now I do need a little commercial break here. I need to pause here quickly and admit that the way I just framed the Canadian model, if had I left it right there, Aaron, it would not satisfy our Canadian friends and particularly those that are studied, you might say learned on the model. So it's important to say also that when you have a culture of innovation, an embedded, large and competitively paid investment team that is naturally going to breed evolution and creativity in your investing programs. So yes, consequently the Canadian model has also become synonymous with heavy direct and co investment dynamic overlays for portfolio risk tilting and I might say one of the birthplaces of total portfolio approach that Kaya of course has written on extensively and that healthy risk tolerant laboratory in the Maple 8, you might say, particularly in the last decades or so, has been a huge source and inspiration for the next generation asset owners and their larger toolkits that we're going to discuss today. So I do want to give them kudos and we'll circle back to that, but at the risk of offending those learned folks and our Canadian friends, I think much of that are residual benefits of building an insourced, high quality, always learning investment office with great people than necessarily the original identity itself. So anyway, you can be the judge of that nuance. I'm not sure it really matters, but that is my read of history. So I want to bring the earlier history of these two methodologies to a close. The parallel development of the endowment and at least the originally imagined Canadian model left us with two distinct approaches to building an investment office. And I think it's important to remember when studying history, as I alluded to in the intro, you always need to look, at least in part, to the original motivations behind actions or the problems leaders were trying to solve at the time. Because I do think, whether we agree with it or not, it illuminates the logic and the explanation, the wisdom as to why things are the way they are. So the problem, the endowment model, as we've alluded to, was trying to solve was poor returns that couldn't support the purpose of the fund and the university. The problem the Canadian model was solving for was an inadequate public pension structure. The country needed a sustainable, highly functioning system to support this coming baby booter generation's wealth and retirement creation, and the current one simply didn't cut it. So as such, and this highly oversimplified summary, given all those disclaimers and apologies, I just felt compelled to add but the solutions to these two problems largely left us with what I would call a binary decision between insource or outsource. Or at least it was a spectrum where your individual decisions on insourcing and outsourcing for each asset class resulted in you plotting somewhere on that single, single continuum. And I mentioned this in the introduction, but for my DJ friends, if I had any DJ friends, I'm not even sure why I wrote that, but my DJ friends, you might think about a simple soundboard, an AV soundboard. This was a single volume fader, a slider button that goes up and down in linear fashion. More insourcing, slide it up, More outsourcing, slide it down. Very simple decision continuum. So all of this leads me to today's vintage of asset owner, that background. Aaron, you'll be familiar with this term of TV shows of quote breaking the fourth wall. You know that one, so explain that one quickly to the audience.
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B
I do. I love that. I think the most tangible example you can give is if anyone here has watched the Office, the classic look at the camera moment during any of those inappropriate and or funny sequences. I love breaking the fourth wall. It's one of my favorite things. So I'm excited for what you're about to talk about.
- [20:00]
A
Well, you're right. So it's when the dimension of the actors shifts and looks outward at the audience. And it's not a brand new phenomenon, but I think it's being much more widely used. The Office, at least in the states here popularized it. But I would argue in similar fashion that asset owners have jumped their own wall in the last five to eight years. So just to continue my DJ or my soundboard illustration, this is not about moving that slider button up or down farther or even extending the range for which the button can slide. It's truly jumping onto a new dimension in my view. So now remember my earlier point on studying history? What problem were we trying to solve? And I think that's important and it's good discipline to answer that here too. Why was or why is this binary slider between insourcing and outsourcing no longer sufficient? So I want to just briefly look back at both models again with that lens. In the traditional endowment model, use of third party managers significantly broadens your expertise and access to new strategies, fresh approaches, idiosyncratic assets, no doubt about it. But it also creates agency problems. So GPs of course are paid on different incentives and they are paid quite handsomely. So one problem post GFC, particularly as the industry outgrew the conventional 60:40 asset allocation as LPs and endowments moved into more private capital and diversifying strategy, what you might call the tax on using external partners got very expensive investment management fees soared and they became a greater and greater drag on returns and obviously stole from other potential areas of investment. And relatedly, when you have broken agency and incentives, but also in purpose and timeline skills, utility motives, all of the above, it inevitably leads to degradation in outcomes. You just can't avoid that. And so the misalignment of interests in a quote delegated model and the resulting loss of LPs controlling their own destiny was one problem that begun to be identified on the endowment model. The value chain you might say needed to be re intermediated. On the Canadian model side, the insourcing, development and investment in building system wide capabilities in order to have a competitive investment management firm is challenging in other ways. Of course you have to find the right talent. And by the way, this is specialized, highly technical talent. And then not just find them, but then retain them. You also lose, you could argue economies of scale and information access by eliminating consultants, large intermediaries, other vendors, a lot of external gps. Thirdly, as much as our LP friends will lament the amount of incoming GP pitches and emails they receive, you will hear this all the time. You do lose the kinetic information flow of emerging gps, niche gps, specialized gps that offer new forms of risk and return characteristics. So you may not even end up investing, but that mosaic of deal sourcing and opportunity and flow of discussion broadens your intellectual aperture. And I think in a purely insource model it's going to narrow it almost by definition, self evidently. So all of this while it flies in the face of what the founders of the Canadian Model, I think, intended. All of this insular focus could, and I want to stress, could result in organizational inertia, complacency, and what our friend Ashby Monk calls innovation sclerosis. And so the other problem was simply the sheer scale and intimidation of building this out and then avoiding the somewhat natural risk of organizational atrophy that can set in once you summit that peak. So these multidimensional challenges, back to our question of why did they need a third model could no longer be answered by oscillating back and forth simply on the dated Endowment versus Canadian model soundboard. But it needed a completely fresh model that transcended the historical options and tried to solve for the challenges of both. So enter the Collaborative model. And I want to say that this phrase is most associated now with CalSTRS because they've explicitly adopted this vocabulary amongst the staff and the board. And Scott Chan, I'm sure will talk about that, but I'm going to use the Collaborative model a little bit more generally to describe this new solution. The Collaborative Model, that language, the vernacular, as best I can tell, was coined around 2016, 2017 again by our friends over at Stanford, Ashby Monk and Rajeev Sharma. In fact, you're going to love this, Aaron. It was perhaps first thoroughly explained in a 2017 Kaya paper, which of course Kaya is the petri dish of the industry. But Ash and Rajeev in that particular paper worked with Jagdeep Bakker, who's the CIO of UC Regents, to outline this idea a little bit further. UC Regents had struck some very interesting partnerships in climate tech and vc, and these seem to be early stimulants for Team Stanford to study and eventually develop a book on the subject. I've mentioned this book before, Reframing Finance. That is just a fantastic summary of much of what we're talking about today. So the authors wrote in that 2017 Kaya article, quote, as a response to the drawbacks of the Endowment and the Canadian models. The Collaborative model focuses on how innovative platforms can be developed directly with other peer investors and investment partners. The platforms or vehicles can help a group of peers invest more efficiently in long term assets, get closer to either a direct investment method for real assets or an endowment method for innovation, but on far more aligned terms. Back to that agency issue. So it's really about using collaboration to seize back more active control of the portfolio. It's about leveraging the expertise of many flavors of partners. Certainly traditional GPs, but also investment management firms, research firms, financing organizations, and even as we're going to see other like minded asset owners and then structuring new forms of partnerships, JVs, special purpose vehicles that remove the layers and disconnects that contributed to some of the agency problems and those high fees I mentioned earlier. It's about rolling up your sleeves to design new investment vehicles that are more fit for purpose, a bit more sustainable and align more closely with the goals of the underlying asset owner and its purpose for existing and finally, it's finding specialized local talent or track records and then financing, investing or even establishing brand new gps that offer access to what might be a previously elusive form or risk premium with superior deal flow and underwriting capability. So Aaron's going to walk us through some of the specifics around the toolkit that defines this new flexible collaborative model. But they're employing all kinds of interesting stuff. There is heavier reliance on co investing and direct investing, but also use of secondaries exploiting continuation funds, sometimes in just one single trophy asset. GP stakes are permanent capital. We're going to talk about a lot. Asset owner consortiums are popping up, derivative overlays, revenue sharing agreements and much, much more. So to beat my earlier metaphor to death, you've gone from this single soundboard fader button to an enormous cockpit of knobs and dials and joysticks and indicators, gauges and handles. And this sophisticated instrumentation is reshaping the organizations from the very core and by extension, as I said earlier, downstream through the entire profession. So in a little while today, as I mentioned, we're going to talk to two leaders in this journey. But I want to close my segment before I hand to Aaron with just a couple of the pioneers that paved the way for this. Just as John Maynard Keynes and Common Fund shaped David Swenson's views, who shaped Scott Koster's and Molly's views at osers? Right? Who were the pioneers here? Well, based on our research minutes from their respective boardrooms and public interviews, it's a familiar bunch that they see cite as far as who they're looking to, who they're talking to, who they're modeling around. CPP Investments, Ontario Teachers, Texas Teachers, apg, the Dutch pension fund gic, the Singaporean sovereign wealth fund, adia, of course, Abu Dhabi's sovereign wealth fund, and we mentioned JOGDEEP over at UC Regents. It's asset owners that we discussed at length on this show. They're often the most enterprising and creative global examples on many fronts. They were the ones charting the course with some very exciting initiatives. So I just want to highlight as I close a couple from that original group so over the last five years the Dutch pension fund APG has extended its direct and co investment core competency and infrastructure through partnerships with South Korea's nps, New Zealand super and gpif, that's Japan's public pension fund, including offering a proprietary fund structure designed just for other asset owners, which is very interesting. Texas Teachers has dabbled in designing separate accounts with KKR and Apollo and also utilize what they deem the Texas Way, which is so Texas, but the Texas Way, which is their collaborative language to pursue GP relationships that can grow and innovate with them. And that philosophy has led to approximately 40% 40 of its private equity program now in what they call principal investments, which is code for direct or co investment. So significant portion of collaborative capability there on their private capital book. The roots of GIC and ADIA and helping to establish global competitiveness of the Singapore and Emirati's economies respectfully has fostered huge comparative advantages from these funds and direct investments across all forms of private capital and a very enthusiastic pursuit of asset owner partnerships that we'll talk a bit more about. CPP employs in their own language instead of the Texas way they call it the partnership model to work directly with their PE private equity GPs to source, underwrite and operate even their portfolio companies. Again as I mentioned earlier, sometimes in just one single asset structures. And speaking of cpp, both they and GIC partner I thought this was interesting because spent a lot of time in my earlier career in Boston and Boston Properties owned like every major class A office real estate building downtown in the Financial District. So CPP and GIC have partnered with Boston Properties, which is the largest owner and operator of class A property in the US for an extensive co investment program. Ontario Teachers, as with most of the Canadian funds, has a massive direct real estate portfolio of their own around the world and utilizes effectively a macro hedge fund on top of their strategic asset allocation to allow for tilts and risk factors as their investment thesis shifts from quarter to quarter year to year. That fund is way too big. It'd be like turning a cruise ship through the traditional asset class shifts so they can do it through this overlay using derivatives and all of this, as I mentioned created seedlings for CalSTRS and OSERS in early 2022. We'll talk to Molly about her joining an asset owner consortium originally conceived by the Kuwaitis alternative vehicle called Wafra Capital Constellation, as it's called is a GP stakes or permanent capital business in alternative managers. OSers and PIFSS, again that's the pension from Kuwait are joined by Rail Pen, Alaska Perm, New York Common and the Swedish National Pension in that consort at Wafra. And then in 23, OSERS also helped fund a brand new VC platform called Collective Global alongside San Jose's Public system. And again with Rail Pen. And as I close CalSTRS, our other guest has committed billions of capital to new partnerships since the formal launch of their collaborative model in 2020. They're just coming up on their five year anniversary of initiating it and that's included real estate, JVs in Belgium, Netherlands, Korea, home building here even in the US and an emerging VC among others. So they claim to have taken 2 billion US of fees out of the system with these changes, which is just striking. And we'll talk again more to Scott about that later. So I'm going to stop there. I think that is hopefully helpful and plenty of foundation, Aaron and listeners to think through how we arrive today. And I think Aaron, what is going to be very fascinating is then bringing us back into that cockpit and all that instrumentation, talking through what are some of those options available, what are the ones they're using most often, and how should we think about the purpose of each of them? So off to you.
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B
It's funny to listen to this real time as you're going through the history and the different tool sets and approaches that a lot of these asset owners use. And I almost feel like this is the Follow up to TPA, TPA Part 2 In terms of we talked a lot about the approach and the philosophy behind tpa and this gets into more of the guts of how a lot of these organizations, and you mentioned some of them, cpp, gic, some of these pioneers of the TPA approach are included in some of these different methods and methodologies to implementation. So I don't know if that crossed your mind as you were going through and doing your own research, but that parallel really jumped out to me as you were walking through it.
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A
Indeed, I was struggling to frame again the evolution of models from the Norway model, from the Canadian model, from the Endowment model to the collaborative model to total portfolio approach. And again, I don't think it's healthy to do a linear extrapolation like one has fully arrived and grown up. I do think it's cherry picking what really works in each and then applying it to your specific organization. So yeah, I don't Have a perfect clean answer for that. But that did cross my mind quite a bit.
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B
So before I get into my section, John, you mentioned me sitting in the cockpit for all this, and an important question is, am I in the Millennium Falcon or the USS Enterprise?
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A
Ooh, you can be in either. Both have a lot of buttons, so I think both work for the metaphor.
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B
Okay, fair enough. Fair enough. Well, I'm going to walk through some of the different vehicles that go beyond the traditional limited partnership models. So buckle up. This is going to be a fun class. As we go through each of these different methodologies, I will just start off and say that there are a lot of different tools that are available to LPs out there, and there's a lot of variations on these tools, but I've tried to capture this into some of the broadest categories. So if you're in this space or you're doing a lot of work in this space and there's a variation of what I'm talking about, apologies in advance, but I'm trying to get the broadest grouping here. But to help you organize each of these categories in your mind's eye, if you will, I'm going to be walking through the following three categories. So first, I'm going to be walking through direct investments, and that includes co investments and true direct investments. Second, I'm going to walk through what are known as alternative vehicles, but I'll call them custom vehicles for the purposes of this discussion. And then third, I'm going to walk through secondaries and nav lending, or what I'll call the creative stuff, and you'll see why when I get there. I've also tried to structure these in terms of complexity, starting with what I think are probably the more quote unquote simpler of these different vehicles to the more complex. After I finish with these three, I'll capstone a bit on some of the things that John just mentioned on partnerships, joint ventures, wholly owned subsidiaries, which tend to pull from all three of these different categories and they work in different ways. So figured that might be a nice way to bring all of these together. The last thing I'll say from a housekeeping perspective is I've collected a lot of different sources and research as I was preparing to walk through each of these. We'll include all of those in the show notes. I just wanted to say that now because I say it every single time. You might throw your phone across the room with the number of citations that have gone into this process. So let's get started with direct investments There are two different types of direct investments that I'll talk about here. Co investments and then true direct investments, sometimes referred to as solo investments. So co investments include involve a GP and an LP investing alongside each other, typically in the same deal. And typically that's an opportunity that's been available to the main fund but is either too large to completely go into that main fund or there's some kind of value add between the LP and the GP to partner together. Solo investments are called solo because they only involve one investor and that's the lp. These deals are sourced and structured by an internal investment staff and they have no outside involvement from the gp. More formally now, the reason why investors typically pursue this way of investing is a combination of increasing upside potential and also lowering fees paid to external managers. Whether you're co investing alongside the GP or you're doing it yourself, you're not necessarily paying that management fee or carried interest to the general partner. Now of course doing direct investments either way requires some additional expertise and ongoing management. I want to get into performance a little bit and help you understand the pros and cons of this. But before that I want to walk through two examples and case studies to highlight how co investments and solo investments are utilized. First, we have to talk about the Canadian pensions. John did a really good job of walking through that history of the Maple model. The Canadian pensions are famous for this approach and a large portion of those portfolios, somewhere up to 80% plus is internally managed. But as John also mentioned, a lot of these organizations take a very hands on approach with their direct investments. And there's a great paper that highlights some of these case studies that we've seen over the past decade or so where Canadian pensions are actually putting capital to work. But they're also working with these portfolio companies in a more operational role. So I think that's one of the cleanest examples of kind of a direct investment where you're getting both a mix of financial returns from putting your capital to work. But generally there's a hands on operational role and sometimes even a societal benefit. If you're looking at things like farmland or infrastructure or some of these different assets asset classes. The second example and case study that I want to walk through is just the rise of direct investments in the US public plan space. And you've seen a lot of public plans begin to jump into the co investment game, but they're not the first movers. So we've seen a lot of activity outside the us, particularly in the Middle east and some of the APAC asset owners. And so you're seeing a lot of public plans having to overhaul their decision making processes from what it was historically to actually compete with investors overseas. And there is an example that we'll link that highlights how co investment decisions in the Middle east might only take a couple of hours for sign off, whereas here in the States it used to be days. And I think part of this is just the evolution of the industry, but also because of that competition that we're seeing and the maturation that we're seeing in this space, it's much less of a buyer's market, if you will, it's much more of a seller's market. So there's two examples that I want to highlight to illustrate how we're seeing this take place in the asset owner space. But let's talk about performance. So what does the historical research say? And I just want to preface this by saying that this is evolving. And so the most comprehensive study that we have actually only goes back to 2018, so a little bit dated, but I think some of the findings of this particular paper are still relevant for some of the discussion. And this comes from Josh Lerner and team over at Harvard Business School and they take a pretty comprehensive examination of a number of different asset owners and they compare the co investment side of their portfolios and then this solo deal true direct investment side of their portfolio. So really trying to compare how do these direct investments compare to the actual funds or peer groups that exist. So on the co investment front, performance is actually a pretty mixed bag on average. So surprisingly, over the period that they examined, they found that venture capital and buyout co investments both underperformed the main funds on average. Now buyouts tended to fare a little bit better than venture capital, but still both on average underperformed the main fund. And that seemed pretty counterintuitive to me. And John, I'd be curious your thoughts on this once I finish here, but I would think that typically GPs are bringing their best deals as part of a value add process for the lp. But the paper and Josh and team argue that it's not necessarily that these are bad deals, it's that they're just large deals. These are typically deals that are not able to be absorbed and swallowed by the fund. And so they need to bring on additional partners as part of that. And as we always say, size is the enemy of returns. On the solo deals side, the findings here were also pretty interesting. Now you can't compare solo deals to a main fund because we're not investing alongside a gp, but you can compare them to private equity benchmarks, peer groups and so on. What Lerner and team found is that the solo deals actually outperformed private equity peer group benchmarks in the buyout space and it tended to be pretty mixed in the venture space. This made sense to me as I was trying to make this intuitive and look at some of these results, especially of skill and if you have access by all candidates typically have less information asymmetry and most investment professionals that are doing this on their own have some kind of training around this. You can run a discounted cash flow, you can model a lot of these different organizations. But I think on the venture side it's the same thing that we see on the GP side where it's all about access. Who do you have access to? And are these entrepreneurs going to go to a public pension or are they going to go to some of the top venture GPS and get access to a lot of those different operators? So from a performance perspective it was very interesting to look at this on average. Now of course there's exceptions to the rule and there's different specialties within a lot of these different organizations but. But John, I'd be curious just hearing this real time. Any reactions or observations from conversations you've had as well?
- [40:57]
A
Well, starting backwards I think certainly the logic would suggest that single assets should outperform other forms of co investing and larger funds. This is just a function of what you describe, which is self selection bias, several layers of discipline around choice and where they want to invest and conviction levels. So that made sense to me. I am a bit surprised and maybe just the co investing universe, the problem of the average, a whole lot of folks doing a whole lot of different things and it just neutralizes out. So I think this is still fairly new for most people. We've talked about some of the pioneers. My guess is if you took those, the longer you're doing this, the more selective, the more accessible, the more choice you have with your GP partners. My guess is you could tweak some of those studies and the approach and the methodology would yield a better return. But I'm a little bit surprised too that it doesn't seem, at least at surface level to add much.
- [41:52]
B
Yeah and I think a couple of observations that I had on this front. One of course this is somewhat data as I mentioned, so I'm sure Josh is listening intently to this podcast. So Josh, if you want to do an update on this study, I'd love to see it. I mean this is pre Covid in a lot of ways and we've certainly seen this space really take off in the past seven years since publication. But. But I agree, John. I was surprised to see some of those observations and there's not a lot of research on it, at least comprehensive research that we've seen. The other thing that I thought is interesting, obviously a lot of these asset owners engage in this to lower fees that they pay to their gps, as you mentioned John, the Maple model, insourcing a lot of their investment capabilities. But there's a cost somewhere. So to be able to have that expertise to invest in these deals, you've got to hire talent that can invest in these deals. And so you may be saving on costs at the GP level, but maybe not necessarily at your operational budget level. And can you attract and retain.
- [42:51]
A
It's funny you say that because I think overall it's a savings to insource even highly technical capable talent. But I mentioned the Texas Way at TRS for example, and one of the things in this article that I had read that yielded that 40% principal investments number, which is really a standout, a unique, unprecedented number on particularly US pension funds, was that the retention had plummeted, that turnover had really risen, that the expectations, the needs, the pressure, the standards and the thresholds on what they needed from their private capital teams had completely changed and had grown considerably. And so Jay Saubi, the CIO and team had to think very hard about the talent HR culture element while they've built out this capability. So there is non monetary cost too, that is extensive.
- [43:40]
B
Absolutely. So that is direct investments. Obviously a lot of work on the research front I think to be done there, but interesting to look at performance from that perspective. So in the second category is these alternative vehicles or custom vehicles as I'll call them. And the best way I can describe these are that it's still a fund, the LP is still engaging with the gp. It just so happens that the LP is a little bit more hands on than perhaps more of a quote unquote passive gp. LP relationship. Now, there's two types of alternative vehicles, GP and LP directed vehicles. If you want to break up the universe, GP directed vehicles are funds where the GP retains decision making authority, determines the investments to own, but the fund is custom in some way and it's catered to the LP's specific needs. This usually entails some form of a parallel fund or a special purpose vehicle that sits alongside the main fund where the GP controls the investment decisions but alters that particular fund on the LP'S. Behalf. On the LP directed vehicle side, it's the exact opposite. So these are sometimes called discretionary funds that might include co investment funds or pledge funds where the LP is calling the shots in a lot of different ways. So co investment funds are aggregated funds that are raised by some kind of third party that are designed to participate in selected co investment deals across a number of GPs. And then pledge funds are where LPs commit capital, but they do it on a deal by deal basis instead of committing to a blind pool that the GP then commits to particular deals. So again, looking at performance and some of the empirical research, another Josh Lerner paper. So Josh, you've got a fan here at Capital Decantan, but they took another comprehensive study at 108 different asset owners with data covering 500 billion US of commitments and 20,000 different investments. So this is a pretty broad study. And again, this is slightly dated, a little bit more updated than the co investment one, but we're talking early 2000s in terms of that study. What they found is that the GP directed vehicles tended to underperform the main funds despite having a high overlap between them. So this simply means that those side parallel funds might invest in most of the deals with a couple of exclusions, but still on average underperformed the main funds. On the other hand, the LP driven funds outperformed GP directed vehicles and sometimes outperformed the main fund. So a little bit more of a mixed bag and maybe a little bit more of a positive light, but generally the LP driven vehicles had a much lower overlap with the main funds, so meaning less the deals went in and a little bit more of a diversification benefit for those particular asset owners. So, John, I know this is a little bit more of a custom way of doing things, and of course there's probably constraints that a lot of these investors are putting on these parallel funds, whether it's sustainability or it's particular sectors that they're trying to target. But any reactions to this as well? I'd be curious if you have any thoughts.
- [46:44]
A
Well, these are really a potpourri of very different motivations, so I appreciate the study. But even more so than the co investment universe, I think we've got to be careful to suggest this is apples and apples, particularly on the LP side. I think the reasons for pursuit of some of these special vehicles are different. All that said, I think the LP directed vehicles outperforming the GP director makes sense logically given the agency issue. So that it's not necessarily that LPs are choosing better assets on balance, I don't mean that GPs are just as smart, if not closer to the action, but the issue is around agency and alignment, so that doesn't surprise me that that has been the case. Motivations are going to be more aligned, so not a lot of thoughts other than nothing particularly surprising in those studies.
- [47:28]
B
Yeah, and it reminds me of the old custom SMA where maybe you're excluding a sector due to your client's preference or there's some tax ramifications. This obviously isn't as relevant to this particular group, but usually the motivation is not driven by performance. There's something else that's going on, but interesting to kind of see how it does impact overall performance. I completely agree, John. So the third category that I want to walk through here is the creative stuff. The reason why I'm calling it the creative stuff is that the previous two examples had to do with funds and there was some creativity around the fund. But you're still investing in a fund at the end of the day and it's still a GPLP relationship that exists. Whereas the two that I'll talk about here, which include secondaries and nav lending, it's still investing in a fund, but there's an actual creativity of using the fund as a vehicle for investment as well. So you're going outside the bounds of that particular fund. So LPs do this in a lot of ways. There's a lot we could talk about here, but as I said, I'm going to focus more on the secondary side and on the nav lending side. So first let's talk about secondaries. So as a bit of an overview, there's two kinds of secondary transactions. There's LP and GP led. Sounds familiar. The LP LED secondary transactions involve an LP buying or selling their fund interest with another lp, and there's typically an approval process that takes place from the gp. This space is the older of the two and has grown considerably since the early 2000s. And this, as we've talked about in previous episodes, has moved from a tool that was somewhat embarrassing, I think, for a lot of investors to either have to liquidate or you get the headlines around someone selling interest in a particular fund to an industry in a space where it's really about flexibility, rebalancing, mitigating risk, mitigating the J curve and potentially some outperformance depending on the vintage year that you're selecting. So quite an evolution. On the LP side, the GP LED secondaries is a newer phenomenon and focuses more on the Underlying assets rather than buying and selling fund or LP interests. Here, the GP has identified one or multiple assets that they believe will still have upside potential but are facing the possibility of selling too early due to the fund's constraints. So the GP sets up what is known as a continuation fund where they'd like to house those new assets. And at this stage they have to raise funds to fund that continuation fund. They do this through a combination of going back to their existing LPs in the current fund and potentially new LPs depending on how many commitments you get from those existing LPs. So this process provides the LP with an exit opportunity if they'd like to exit the existing fund, but it also gives them an opportunity to commit to further growth potential in a new fund or some combination of the two. Sometimes LPs will liquidate part of their shares and then commit the other part as well. So there's two examples of asset owners that are utilizing secondaries that I want to highlight. So first, in 2022, CalPERS established a secondaries program and is both a buyer and a seller of LP interests. So primarily LP led secondaries. And in their words, they want to use this growing market as both a portfolio optimization tool and an opportunity for structure alpha by taking advantage of some different mispricings. So this is a pretty common use case that we've seen as the market has matured and more players have moved on, but interesting to see some of these larger asset owners really moving into the space wholesomely. The second is the Australian Aware Superfund and they said that they plan to invest more in continuation funds. So we're talking now on the GP led secondary side of the ledger. And this was just at the end of last year. So at the time of the announcement their deputy CIO commented that this is where the market opportunity is going in the secondary market and they like to take advantage of it. And you can point to a whole host of reasons for that, whether it's capital formation, the fact that companies are staying private longer, there's a whole host of things that we've talked about on previous episodes, but two very prominent asset owners globally that are investing in this space. So that's secondaries in terms of getting into the guts and mechanics of this space. We did an episode back in season one where we get into the guts of secondaries. So if you're interested in the space, I'd highly recommend checking, checking that out if that interests you. And then I want to talk about nav lending. So Nav Lending or net asset value lending is part of a broader financing category in the fund space, but is one that has grown considerably in the 2000s. I'm going to oversimplify the universe a bit, so I apologize for any of the NAV lending nerds that are listening. But there's effectively two phases to GP financing. There's subscription lines and then there's NAV lending. So subscription lines provide short term revolving lines of credit. And these are used by gps in the early stages of a fund's life. These loans are typically made before the GP has actually made any investments. And so the underlying collateral is the GP's unfunded commitments from the LPs. Historically, banks have really filled these loans and they have a very low LTV. So typically 25% of those commitments. Now, once the commitments have been called and the funds are invested in portfolio companies, GPs can take on what's now known as a NAV loan. So rather than collateralizing the commitments from LPs, NAV lenders collateralize the funds pool of the underlying assets. So you might be asking, why would GPs and LPs want to engage in NAV lending? So for GPs, NAV lending can provide an additional source of non equity capital which can avoid diluting existing LPs. And the cost of borrowing is typically lower than if they borrowed at the individual asset or company level level because the lender is underwriting the entire fund as opposed to one particular portfolio company. By the way, this is a tool that really took off during COVID 19. So as we saw the economy shut down and businesses started to struggle, NAV lending really rose to prominence as a short term and relatively cheaper source of financing during a tough time. From an LP perspective, there's two rationales for providing NAV loans. First, it allows the LP to earn interest in a pool of assets that they already know. So they've already underwritten the fund, they know the GP and they're comfortable with the particular investment portfolio, but they don't actually have to put more equity into the fund. So they've already committed their equity to that particular fund and they're interested in earning an additional return. So these loans are typically at the top of the fund's capital structure and the collateral is known. Second, NAV loans can prevent forced or premature exits by providing additional financing to the gp. The GP may not need to exit their positions as quickly in order to generate liquidity. So this is a very similar rationale to what we see with continuation funds. Now. Of course, this doesn't come without risks. The most obvious one here is leverage. So by providing these loans, you're increasing the funds leverage, which can be bad if the asset values are marked down or written off. And additionally the LP is now both an equity investor and a lender to the particular fund, which during tough times can create a bit of a conflict in terms of which side do you take on particular issues. Now, in terms of performance, NAV loans can also significantly impact distributions. So while NAV loans may be cheaper than the traditional asset based lending, in some instances they're still expensive and could be higher than the expected return of the fund sometimes. So if you're both a lender and an equity investor, that could lead to distributions coming back sooner than expected simply due to the interest that you're earning on that particular component of the loan. But it might come at the expense of the equity investment down the line. So you might earn some distributions, they might be accelerated because of the interest, and you may not know where they're actually coming from. This is sometimes referred to as synthetic dpi, which can really juice IRR and TVPI multiples in the short term because you're earning those returns much sooner. Again, if you find this interesting, Juliet Clemens wrote a great piece for Pitchbook that goes into a really deep dive into the space and walks you through the history, some of the performance considerations and some of the other color on performance that I just walked through. And additionally ILPA released some guidance on this as well that we can link in the show notes as well. So John, curious again, the creative stuff, if you will, reactions on the secondaries and Navlone side.
- [55:45]
A
Well, I think just as we've walked through these categories, Aaron, I think the performance stuff is interesting, but I think as a segue to our guests, we need to be careful to suggest the decision tree is about in each of these cases. Will you get better performance if you do it this way versus the traditional LPGP drawdown fund in very few cases is performance. The headline here again, as I've mentioned, what Scott will probably say is that the headline, at least with the board, was about cost savings. It's certainly much more than that now, but that was the headline with Molly. It was about a very creative new platform for investing in vc. And I've also talked about things like control, convenience, getting closer to the investment alignment. So all these things play a role and as part of that larger decision, Mosaic Performance is one of them. And I think you made it very clear we're still very early with a lot of these two. So I would caution listeners to either be making their own choice based on that or to suggest that the acceleration in this is a function of better performance. Because I just think the jury's out. And in many cases these asset owners would tell you we don't really care as long as they're not degrading. There are huge non monetary and other benefits that we are mining that is unrelated to the number.
- [57:01]
B
Yeah, absolutely. I mean, if you're going into any of these for purely performance, I think that that's a misguided. As you just highlighted, John. Agreed. So John walked through the partnerships, joint venture, fully owned subsidiary categories really well before I started my segment. So I'll highlight a few examples of some that we've seen that pull from a lot of these different tools that I just walked through. I won't rehash the description of each of these, but I think it's worth worth highlighting a few of these. So on the joint venture side, and this I think ties really nicely with the partnership and the collaborative model that we've seen at CalSTRS is CalSTRS as part of their asset pool has what they term an innovation portfolio. So it's one of the sleeves that they have put together which is meant to fund and partner with different innovative asset managers. And I think a really good example where we're pulling a couple of these different tools together is in a recent article in an interview that Scott did. CalSTRS recently began ramping up its private credit exposure through the innovation sleeve. So when he walks through how they did it for one of the very first investments in this sleeve, it wasn't just investing in a fund, they didn't just do a traditional LP GP partnership. Instead they did three things. One, they did commit capital to a fund. So the more quote unquote, plain vanilla side of the decision process, then they also engaged in some co investment opportunities and then took a small ownership stake in the GP itself. So they're investing in private credit through a GP in a variety of different ways. So that's one interesting example. On the other examples here on joint ventures that we've seen, there were 27 Australian super funds that all took a collective ownership in ifm, which is an infrastructure manager out of Australia. And the idea behind this was that they just wanted to access infrastructure, but also do it in a way that fit the needs for all those particular supers. So partnering with a GP and doing it through a joint venture created this sense of alignment between the LP and the GP to execute on those goals. On the wholly owned subsidiary side, there's two examples I want to highlight here to finish things up. One is Saudi Arabia's public investment fund and they recently partnered with Brookfield where they established a $2 billion dedicated Middle Eastern fund. And the point here was to attempt to attract some foreign investment and diversify its economy, aligning with the government's Vision 2030. So of course investing in the fund but also partnering in a more of a joint venture, wholly owned subsidiary type of way. And then of course I'll wrap up here with two Canadian examples. One is the CPP's ownership of Antares Capital Private Credit GP and then the British Columbia Investment Management Corporation or BCI's ownership of Quadrail Property Group or Real Estate GP. And these are just examples of of pensions taking a very hands on approach to working with GPS and benefiting directly from their expertise and ultimately generating returns for their constituents. So John, class is dismissed and I will turn things back over to you.
- [60:03]
A
Well, as we promised, the cockpit is sophisticated and busy and a cacophony of lights and instrumentation. So that was a lot. But I think provides really good context for the ways that asset owners are evolving and modernizing. We really want to bring these to life. We keep mentioning Molly and Scott at CalSTRS and OSERS, but the guest segment I think nonetheless is going to make this very practical what has so far been conceptual through the last hour or so. So Aaron, really appreciate your hard work on that. Very, very helpful to outline the taxonomy, the tool belt as we said. And so listeners, as I promised, stay tuned for Michael Gross with SLR at Halftime. And then we'll be back with our guests of honor. Well, welcome back to Halftime in this episode of Capital Decanted. And I am just delighted as promised, to be here with Michael Gross, co CEO and co founder of SLR Capital Partners. Michael, welcome to Capital Decanted.
- [61:03]
C
Thank you for having me.
- [61:05]
A
Well Michael, I thought it would be helpful for the listeners and certainly me to get a little bit of a tutorial, a primer on ABL on asset backed lending. I think this is one of the hottest and trendiest areas as a subset of this private debt explosion that we've seen in the last five to seven years, let's call it so it has advanced and matured considerably in the post Covid days. So I wonder if you could just quickly walk us through the categories, the taxonomy that make up this asset class. Sure.
- [61:32]
C
And it's a very timely question because as you mentioned, it seems to be in 2024 and into 25. This is the hot area. In 2023 it was quote unquote the golden age of private credit when you saw a real explosion to cash flow lending. And now we're seeing is people moving beyond that that and looking to find other ways to make money within private credit. I think it'd be helpful to begin by distinguishing between ABL and ABS and ABF versus specialty finance. This Alphabet soup can be very confusing to new investors and allocators to the space. Yet the risk rewards in financing the underlying collateral of various hard or real assets can be very different. The ABL market asset based lending has traditionally been defined by carving out assets within working capital which can be quickly converted to cash. And the most common types of assets here being financed are receivables and inventory. And this is lifeblood of US companies and it's been around forever. But today we are seeing more private credit managers expand the opportunity set by going into not necessarily ABL but into ABS and abf which include financial securities that typically have a CUSIP or extend further down the balance sheet to property sale leasebacks, plant equipment and ip. And it's interesting that the financing of these financial securities that has been very prevalent in the press and very prevalent within private creditor manager marketing materials includes assets that tend to be more associated with the consumer, like credit space, like credit card receivables, non agency residential mortgages, auto loans and student loans. These pool of assets, financial assets tend to be very large and present very much scaled opportunities for large private credit managers to distribute and sign, while also presenting opportunities to be financed by insurance capital. We're a little different and one of the reasons we're having this discussion is we've been focusing on asset based strategies now since 2012. So this is not a new flavor for us. And we do it for a variety of reasons and we'll get into that a little bit later. But the type of assets that we do with an ABL lending are stretch abl, health care, ABL equipment finance, inventory finance, life science finance and lender finance. And these are all strategies that are extremely high in labor intensity to both source service and monitor the collateral. And as a result, the reason we like to be in these businesses and the reason why investors are extremely interested today is there's what I like to call the complexity premium involved with these because they are highly complex strategies and as a result our borrowers tend to pay higher returns, which allows us to generate higher yield toward investors and other mainstream lending strategies.
- [64:12]
A
You alluded to allocators A little bit. And I'm curious how your conversations go when someone is constructing a diversified portfolio with all types of risk premia. You talked about higher rates and returns. These are obviously different drivers, business and economic drivers than maybe your pure vanilla cash flow direct lending. How do you counsel them to think about where this fits in a portfolio? Michael?
- [64:36]
C
Yeah, it's a great question and we're having these conversations constantly. But I think in answering that question it's first help us understand why ABL is in vogue today from an investor perspective. It's attractive to allocators investors for its absolute return and its countercyclical profile. And that counter cyclical profile comes from a recurring current income stream in the high single digits to low double digits. It doesn't have much correlation to base rates and importantly doesn't have much correlation to the cash flow lending strategies that you alluded to to. It's also an inflation hedge and it tends to have higher recovery rates from collateral values and less volatility than cash flow lending collectively. If done properly, an allocation to ABL should create more attractive risk adjusted returns and expand a portfolio's efficient frontier. We like to talk to our clients that ABL loss rates tend to be lower than cash flow loans and importantly they are more constant throughout cycles whereas cash flow loan loss rates will vary based upon the economic cycle. And also lastly direct lending, more traditional direct lendings become extremely competitive and borrower friendly. And with the advent of these tremendously large perpetual private BDCs, rates been coming down as structures are getting compromised and you do not see that in the asset based lending space. What we have found though is that allocations to abl, whether it's from a pension fund, an endowment or an ria, still relatively early in its adoption. Yet the opportunities for access have increased meaningfully over the last couple of years, including from the asset liability mismatch dynamic that took place at the regional banks in 2023. But we do think there's still a challenge here in getting clients to move into the space because ABL is still grappling with the bucketing problem that private credit used to have versus public credit. Most often we find the decision to allocate the ABL follows a pre existing investment in direct lending by these parties. And lastly, I think most allocators view this direct lending exposure as private credit beta and are now looking to ABL and niche lending strategy to provide them with private credit alpha.
- [66:37]
A
Yeah, it's really interesting. It is a bit of a mashup in a way in that it shares some DNA with real assets. You mentioned inflation protection. And then certainly it's fixed income in its very essence as far as being private debt like and with a little bit of a premium given the return stream, and yet it has very low loss rates. So it's a very interesting combination that you're charting a new course here, Michael, even though you guys aren't new to it. So we're going to have to leave it there, listeners. And if you're interested in more of a primer on private credit, the entire space overall, we did a dedicated episode on that in season one last year. So, Michael, thanks so much for joining us. And listeners, stay tuned for our guest segment. Well, welcome back to Capital Decanter and I'm just delighted to welcome in studio Molly Murphy, CIO of OSERS and Scott Chan, CIO of CalSTRS. Scott and Molly, welcome to Capital Decanted.
- [67:32]
D
Thanks for having me.
- [67:34]
A
To both of you, we are just thrilled that you've joined us for this conversation. I think it's very fitting because you've been, as I called you in the intro segment, exemplars of this new model of this evolution. And we're really excited to bring to life some of those concepts and some of the history we discussed in the intro segment. And so I thought I would start start with a question to both of you just to frame history and this change in approach for our listeners. And Molly, maybe I'll start with you and then we'll jump to you, Scott, but I'd love for you each to explain maybe the history and the timeline, if you can pinpoint it, of what influences or catalysts moved you out of what we would historically call the endowment model, where you were relying on traditional LP GP drawdown funds, traditional GP relationships to something that is much more creative and flexible and has all types of different partnerships and new approaches. Anything you can help us on the timeline and evolution of that again, starting with Molly.
- [68:33]
D
Sure. So I joined OSERS in the middle of 2017 and I want to say the mindset change came before any activity. So as I was coming onto OSers, I did what I call the listening tour and I sat with all the different stakeholders, board of trustees members, high level staff and said what's been working, what's not been working, the basic stuff that a new CIO will do. And what I heard repeatedly was we don't want to keep doing what we've been doing. It hasn't yielded results. We don't feel like we're taking advantage of opportunities that are Even in our backyard, let alone the globe. So there was a real mindset, I don't want to say a mindset of change, because change in pension plans is always incremental. It doesn't abruptly hit it, but it was already in the water here that we had to change what we were doing. And so what I think really though was the first moment of change was because of my network in my previous roles, I got us access to a direct investment in a venture company out here in California. Now, mind you, we had been doing nothing. We still did fund to funds for our private equity. So we jumped the sharks, so to speak, and went directly to probably the most risky thing you can do, which is a direct co investment with a GP you haven't already had in your roster at a time when you're transitioning everything else. So it worked out really well though. And I think that that opened the door for all the other things that led to where we are today, which is thinking more about deals, less like allocators. But I think 2018 was a seminal moment when we put that first capital capital in the ground.
- [70:23]
A
Well, we're going to talk a lot more about some of those examples, Molly, that you've led since your arrival, Scott. So you've been in the CIO seat six months, but you've been overseeing this investment program and what you guys call the collaborative model for much longer. When did this all take shape for you? What was the moment or the catalyst for CalSTRS?
- [70:40]
E
Great. And again, John, Aaron, thanks for having me on the podcast. I'm really delighted to be here and especially delighted to also be here with Molly Murphy, who I know is fantastic. So, so thanks for that. And if I were to identify a couple catalysts, it actually airs. It rings eerily similar to Molly. When I joined as the Deputy CIO at CalSTRS in 2018, I did a listening tour and my wife will tell you I'm not good at listening. So I was dead set on trying to get off on the right foot. And one of the things that came out of that was the cloud model, which is CalSTRS investment strategy, to build or bring more of our assets in house and reduce costs, boost returns and control risk while leveraging our partners to achieve similar benefits. And in the private markets is where we do more of leveraging those partnerships than in the public markets. And so I really wanted to define not only the strategy, but how is CalSTRS going to compete in the marketplace? What is CalSTRS strategy? And the collaborative model has become this Strategy, I would say another catalyst for us was the acceleration of private market allocations. And so today in private markets and alternative assets, we have roughly 44% of the portfolio, so call it over 50 billion of assets. In my five, six years of being at CalSTRS, we pushed into and we knew as we diversified our portfolio into that realm that was going to be more costly because it's a more costly form. But could we enhance our net returns, enhance the diversification of the total fund? If you look back, we've definitely done that, but we call it bending the cost curve. How can we bend that cost curve to the degree that it's a little bit more aligned with the interests of our trustees? A couple large shifts then unfolded in terms of marking this acceleration. I would say in the time period that I've been there, call it 2018-2023, because if you looked at the evolution, we've been doing this direct investing for a very long time, but it was mainly in the public markets. And sure, there was a little bit more of the public markets and global equity and fixed income that we wanted to push into. Today we're anywhere between 75 and 85%, depending on the public market strategy of direct investing, where we have our own teams, our own portfolio managers, we trade our book, et cetera. But in the private markets there was a nice Runway for us to continue to do this. So a couple of large shifts really enabled us. Number one was building a successful team. And as we were going to become more complex, sophisticated direct investors, we're leveraging our partners to do the same. We needed to spend time training our own staff, making sure that they could facilitate these new deal structures, but also hiring more resources to be able to implement the strategy. So to give you a sense of context, we probably hired roughly 175 people or so within the six years that I've been here at CalSTRS. That was a big evolution or a big enabler. The second big shift I think for us was just to become more nimble and responsive in the marketplace because the closer you get to the transaction, the more dynamic you're going to need to be. So hiring staff was one element, but really delegating them authority to make decisions where the decisions need to be made. And so if I look at the divisions, each one has their own investment committee and they can make decisions the same day if need be. Fortunately, the market doesn't always call for same day decisions, but we wanted to staff them and give them the delegation to do that. And the Other element, I think, which was as we evolved, we certainly needed to do was make sure that not only the investment team was nimble, but we needed to streamline operations all across our back offices and across the organization and things like procurement and technology and HR. And I think first state entities like CalSTRS, we're competing in a global marketplace where they don't have state rules. So how can we become nimble in order to do that? So I think those were some of the big catalysts and shifts and enablers for us. But I'd say 2018 to 2023, we really accelerated the CLAVER model. If you looked at the number of transactions at the end of 2017, for example, we had 106 Clav model transactions. Last count in 2023, calendar year end, we had 425 in CO investments and private equity I started, we had 2.5% of our portfolio. Today it's roughly 25%. So we 10x that. And I think you mentioned we've been able to reap cost savings, but more and more we're moving towards better control of our risks and more alpha production. So just to give you a sense of how this has accelerated over the last six years.
- [75:01]
B
So Molly, when we were going through the initial segment and walking through both the history of how this model has evolved and then some of the tools that are available to invest in this new approach, a lot of this came down to cost management being the initial catalyst. And Scott mentioned some of that in his remarks here as well. But beyond costs, what are some of the other objectives that you all are trying to accomplish? And then in terms of measuring success, how do you do that against more of a traditional LP GP approach?
- [75:30]
D
So I think OSERS came at it from a different perspective than CalSTRS in that regard. We are always cost aware. So that is embedded in our ips, our investment policy statement, that all things being equal, take the lower cost option. But there's very few times when all things are equal. But what we really need to do is we needed to enhance returns. So OSERS had lived in the bottom quartile of its peer group for about 10 years when I got here. And that was part of the direction I was getting from all stakeholders is that we're tired of being in the bottom quartile. We need to fix this. So we were on a path to move up in, I don't want to say the rankings, that's not what this is about. But perform better for our stakeholders and not have the investment program increase any of the unfunded liability, which is what it had been doing dragging through that 10 years post GFC. So a few things were happening. We were looking at the entire book and saying how do we do better at manager selection? How do we do better at cost management? How do we enhance returns? So lowering fees and enhancing returns are two sides of the same coin to the point that fees matter to returns. What we were trying to do was find better optionality and take advantage of the growth of the market in a better way. So I think we were coming at it a little different. But of course we monitor costs. We want to discern and mediate the cost of privates, especially as Scott mentioned, they're the most expensive part of your book. Anywhere from 2 to 4% gets lost to the GP. So that was a big part of what we wanted to do. Plus we were paying middlemen along the way. We still had a lot of dependence on fund of funds and consultants to help our process along. So getting all those layers out, absolutely improved returns. Again, we want to just capture the 4% we're losing, but we want to enhance that. Do we have a metric for that yet? Not quite, because we're still too new in that part of the book to really have the long term results to measure. But we know we're on the right track for a few reasons. We know that our co investment book has been the best performing part of our PE book by a measure of five times. So we have been proving deal selection from that perspective. But long term results are still on a TBD for the program as a whole. But we also want through this to build a more resilient portfolio. So being able to pick and choose our exposures is very, very important to us. And we talk a lot about at our size and scale, we're big enough and small enough all at the same time. We have about 25 billion AUM so we can write a nice check to good partners. We don't need to write the size checks that Scott needs to. So we still can be in what I call the white space of the market. We've told our board and we've educated our board that we're going to be first movers where risk adjusted returns can be found that add to our bottom line. So we are not shy in going into things well in advance of the rest of the market participants. For example, in private credit, and this is under my predecessor to start, but my predecessor and the board got into private credit in 2011, 2012, so we were very, very early. It Wasn't even really called private credit yet. We have now evolved that program. I laughingly call it version 3.0. We might even be into 4.0. But we barely do any new direct lending that unsecured corporate direct lending. It's a flow business business. Everything's being commoditized, you're just getting current yield. So we first moved about five years away from that into securitized asset backed lending, which is now starting to become the talking moment in this private credit evolution. But we've been doing it for five plus years and now we're going into the more niche specialty finance zones. So that's been our DNA. And again, a lot of this is too new to do real benchmarking, but we know that we're looking for return enhancement, disintermediating fees and the niche specialty zones. We hope as we measure our correlations inside our portfolio that we're building more resiliency. So we'll be monitoring all three of those aspects, the three legged stool to make sure that we're on the right track. But early results just say that what we've done in Half House has been better than what we've been getting on a net basis from anywhere else.
- [80:15]
A
Scott, similarly, maybe as Molly talked about returns, you alluded to cost, you guys have been very public. I think it was actually April Wilcox, your colleague, a good KAYA member, I might say that I think reported at your November board meeting that you've now saved 2 billion US including a whopping 360 million if I have my numbers right, in 2023. So I know the headline initially at least least was about cost savings and as Molly said, there are real return benefits if you can find the right partners. But you also alluded to some of the non monetary benefits and I'm curious whether you could talk about whether those were intended or almost learned or by accident along the way. Things like control and speed and flexibility of your investing programs. What have you learned about the benefits of this model beyond the numbers?
- [81:02]
E
Maybe just starting with the numbers. Our focus really is the net returns and I think a lot of the dialogue has we've led with the cost savings because the juxtaposition between what it costs for internal staff versus what it costs to deploy external management is really significant. And we had to justify a return on investment in terms of how we were going to hire staff to eventually create a lot more value for the fund. But if I look back at the last five or six years, our value add has been growing. In other words, the Amount of distance we beat our benchmarks by has been been increasing in a very linear fashion, which I don't think is going to last forever. But if we save 2 billion or so plus in cost savings, we added over $10 billion of value to the total fund. And so you can say maybe 20% of that or even less than 20% is cost savings. Most of it's going to be in developing better net returns. And of course I can't even quantify the risk benefits, but I'll try to get to that qualitatively. The basic decision is what can we internalize or do better through leveraging our partnership on a net basis? Because if we don't do that, then it's not worth doing. Because the whole idea for us to develop better net returns with the same or less amount of risk, and the good news about some of these structures is that I believe that we're structurally creating cost savings, we're structurally creating alpha in ways where we're sharing in economics and things like that. So let me just dial it into two important elements that you're getting to. Number one is we're attempting to be the global partner of choice. And what I mean by that is we want to be 1, 2, 3 number call in terms of our partnerships with folks, because we know if we can do that, then essentially we'll establish the best transactions in the world, we'll get a look at it. And for me, that's about developing a staff that is trusted by our partners, that they have expertise and are really knowledgeable. One of the nice things we have at CalSTRS is stability in our platform. So our long term turnover rate's 4% and I think that's very helpful. As folks are looking to transact with CalSTRS, they know that, that this senior team is going to be here for a very long time, so we can make very long term decisions in our investments. Like I said, we strive to be nimble and responsive to match the responsiveness of our external partners. And we try to turn the typical JPL relationship on its head, meaning that they're courting us, we're courting them because we know that the best managers in the world are highly selective too. They don't need to work with CalSTRS at the end of the day, even though we have a lot of capital and we have a great reputation, but it's got to be a reciprocal relationship. The second element that I think is really important is that we don't have a one size fits all model and so we try to develop flexible structures with our partners. And I'm talking more about the private markets here because again, in the public markets we do that mostly all in house. When I'm talking About structures like SMAs or CO, investment structures, revenue shares, joint ventures, minority or majority interest, the key here is greater alignment of interests, particularly around risk costs and greater returns. And so if I start with just risk control, I like to think in these structures we have more influence and rights than a typical commingle fund. So if market conditions are changing, we can redeploy capital. We also develop a much greater understanding of our portfolio of companies from a bottom up perspective. Not necessarily on par with the manager, but we can make better decisions. We can even mitigate or dispose of risks in the marketplace. As we garner a much sharper view on that, we've got greater influence. A lot of times we're on the advisory board. In the case of ownership, when we own asset managers, we're on the formal board, the government's board. So we have a lot more influence. And I think this has particularly been important over the last two and a half years where liquidity is really dried up. There's been going back two and a half years ago, 60, 70, 80% reduction in exits and transactions depending on the private market's asset class. So if we for example, own five or six real estate operating companies, in fact we own one of the largest residential real estate developers and operators in this country, we have a lot more control over that liquidity, liquidity where we want to deploy it, what submarkets to put it in. And the other thing I would say is that beyond risk to me, we have a pyramid of transactions that goes up from the bottom and the base to the top in terms of its complexity and sophistication, but also the amount of resources then we need for staff. So if you look at the bottom, maybe it's LP relationships and CO investments and SMAs driving cost savings. But as we move forward and up the chain, we're doing joint ventures, revenue shares and in the middle and the top ownership. And that's where we're sharing more in the economics of these endeavors. And so we need greater staff resources. And obviously the transactions look like a pyramid because when we own a organization at the very top, it's going to take at least two dedicated, if not more dedicated staff from CalSTRS to daily manage that relationship, sit on the board and manage it strategically. So I would say that our evolution has gone in that realm from this cost savings and control from SMAs and Co Investments and moving up to sharing economics and controlling risk as we've become more sophisticated. But from my vantage point, that's a very healthy dynamic and for us it's really about driving the net returns across those three variables.
- [86:13]
B
So, Molly, you're famous for some of your outside the box thinking and approach to investing and two examples that come to mind that we talked about in the prior segment are, are Capital Constellation and Collective Global. Would you mind just talking through both of those partnership joint venture approaches that you've taken and the philosophy behind each of them famous?
- [86:35]
D
I'm going to have to figure out how to live up to that. But listening to Scott, what I react to there is you have to know who you are in order to figure out what you're capable of doing. So we don't have the capital obviously that CalSTRS does. So we're not going to own outright the largest real estate player or even own a share that matters in that transaction, even if we could come to the table. So we have to decide how to spend our capital, where we get the most alignment and payback. And so as we were thinking about how to do this OSERS way, again still focused on optionality because. Because again, we're not going to be big enough to buy meaningful minority stakes directly into some of these companies, nor are they going to look at us as the partner they want if they want sizable capital. So when the GP stakes opportunity set started to become talked about, we looked at all of them and thought, well, is this something for us? But the model is largely that you buy a minority stake in someone else's business model and you sit on that and then you'll sell the stake at the end of the life of the stakes fund. But it's really a middle teens return profile. And we said that's just not enough for us. We're not getting enough out of that. At osers, we're like, we're just not that set it and forget it passive investor that a minority stakes play is about. So when Capital Constellation flew into our front windshield, so to speak, and we started to pay attention, what we liked about that opportunity in particular is they were making considerable investments into the GP's funds as well as taking a stake. So to us we're like, okay, now that dollar that we're putting in is working twice as hard. We're getting the asset class returns and we're also getting the revenue share or the economics of the GP at the same time. So we're getting the GP'S full economics. We're getting the fund return which they're investing in themselves, themselves, plus we're getting a share of their economics. The other caveat was it was going to be a consortium of people like us Global Pension Plans, Global Sizable Allocators. And so we were going to be in a room with a group of people that we thought would have alignment of other interests even beyond Capital Constellation, which has turned out to be true. So when we look at putting a dollar in place, we're always saying, what more can this dollar do for us? Does it get us in different conversations? Does it get us different economics? Does it get us optionality? And so this one was a little different than the other GP stakes opportunities that we had seen in the past. That's why that one was attractive because it hit all of the buttons and checked all the boxes to use the analogy that we really needed to make the returns we were seeking. So then you fast forward to Collective Global, which is my favorite thing to talk about right now, because not only does it serve a need within OSers, but I think it really serves a need in the innovation ecosystem, which, near and dear to my heart, sits in California largely. And so one of the things that our board said early on is there's so much going on in California, why don't we do more here, here? Because, I mean, if you look at all the statistics, the state of California is one of the largest GDPs on its own globally. It's growing faster than the rest of the United States typically. And there is a huge ecosystem in Southern California for biotech and some other things. And then you have Silicon Valley that has the breadth of all of innovations. And me personally, I'm just a tech geek. So we have been following the AI story, blockchain, crypto story for quite a while. So it just all made sense that at a time of distress in the marketplace for VC and the VC economy, that someone like OSERS could step in and provide capital. The question is how? You can't boil the ocean and OSers can't save all the ills a certain industry at a certain point of time. But my connections at Capital Constellation became conversations that led to the creation of Collective Global. So all these things synergistically get you to the next thing. I had this idea early on to say, why can't OSers do stakes in VCs, the ones we trust, the ones we know. I've been doing VC investing for 20 years. This seems like something also that the check size equals what OSers can do because VCs are small. So all those things matched up. But I wasn't giving up my day job and I wanted to do this for OSers. So finding partners to go down the crazy path of discovery on this idea was important. And one of the gentlemen who had been instrumental in bringing up Capital Constellation, he and I just started talking and it percolated the idea for about a year and a half before it was ready for everyone to take a leap of faith. And then the connections that were made LP to LP started the conversation about well maybe some of the Capital Constellation people would want to be in on this. And you fast forward OSERS put seed capital in. We were the first capital in September of 2023 and mind you, the conversations just crystallized in May of that year. So within a four year time frame frame, lawyers were hired, documents were created, the platform was structured and a launch party was hosted by OSERS in Newport Beach. So this was pretty quick and it had to be because it needed to be timely. But about half a dozen of the capital constellation LPs joined that launch party just to hear the idea. And since then OSers and two more of them have become founders. So these things matter and people want to just say you can do everything with AI and you can do everything from your seat wherever you are on your computer. But these personal connections launch really fantastic ideas because people have to trust each other when you're breaking new ground. So hopefully this is the first dedicated VC staking platform. What we like about it, again we're doing the same model. We're going into the fund largely fee free, carry free by the way to get into the fund. So you're getting the GPS that can economics straight out. We're taking a co investment stake into their funds so we're getting revenue share in economics. We also get if they end up being more successful because we do believe that VC is institutionalizing to the point where there is going to be M and A activity amongst gps in that space. And we're getting two layers of GP stakes because we're founders. We took a stake in Collective Global as well as taking a stake in the VCs that we're finding. And then OSERS also is committed to be doing direct VC staking through this platform for any dollar amounts syndicated above and beyond what the fund can take. So we're doing four transactions for every dollar it feels like in that particular place. So that matters to us. The size was appropriate. We're already VC investors. We sit in the VC economy. You have to identify really strongly in your core and your board's core and how they envision their system to get these things launched. And this just checked a lot of boxes for us.
- [94:21]
A
Well, there's no surprise then as to why you're famous, Molly. Those are fascinating, very creative examples. Two things quickly to underscore. First of all, a Newport launch party sounds unbelievable. Thanks for that invite, by the way. But perhaps more topically, I think you emphasized something that I think is so critical that we talked about in the intro segment, which is this idea of this collaborative model. Generally speaking, the networking aperture, when you open it up, begets more relationships, which begets more relationships and more deal flow and opportunities and looks at at bats. And I think that is underestimated for those that have not played in the traffic directly. So I think that was really well said and I appreciated you bringing that to life. Scott, I want to double click on the staff issue you've highlighted already, twice. I think you said 180 ish people already in the time. Just, just you've been there. When we think about this model, obviously there are technical specialist investment skills that you need. But I would also say to that point I just made back to Molly, there's this idea of social capital, networking capital that probably pressured your entire organizational structure and design. So I'm curious how you thought about not just the number of people, but also how to build the machinery in a way that would be fit for purpose for this new model versus the old model.
- [95:40]
E
I think that I'll spend a lot of time talking with the team and as we look back at the last five or six years, all the credit goes to them in terms of the value that was created. And I think they've done a fantastic job. I work with an amazing team of folks, but just maybe going back to something that Molly keyed in on, I think for us there's a bit of a cultural shift here because you're talking about a deal structuring creative mentality where you go out and really the Canvas should at CalSTRS be wide open, open all the way from an SMA & Co Investments to ownership. So I want to make sure even today I don't think that every investment professional at CalSTRS has the capability feels comfortable like I can traverse any of those transactions. But I hope that over the next five years we get to that point where every investment professional is like I can pull out any of the toolkit. And more and more what we're seeing is that some of the more advanced divisions have learnings and a whole ecosystem developed for other divisions that want to get into, for example, ownership for the first time. And the. And so I think early on there were some areas of CalSTRS where they were very on the far end of innovative. From a structuring perspective, I'd call it the real estate team, for example, they really grasp the idea of doing joint ventures. They grasp the idea of ownership. And if I look at the book today, maybe 80% of it is controlled through these collaborative model structures. And so they've really gone on the far end of it. And we've had other areas where private equity we were just going from 2.5% of NAV of CO investments to 25% and beyond. So culturally there were some areas that needed a kickstart. I remember early on helping facilitating a team doing a private lending deal where they did 500 million or so in investment as an LP, 500 million as a CO investment, reducing fees by hopefully half and then doing a revenue share for the other and just building in the structural cost saving, structural alpha. And what we're left with is not market risk, but operational risk. So how do we combat that? You sort of mentioned one is the hiring that we've went through, but also we've spent a lot of time on the operational elements of it, making sure that we can mitigate these risks structurally for us. Because the whole idea for us wasn't to take on more market risk. We knew we're diversifying into the private markets, but we wanted to take operational risks that we felt we could mitigate through these structures.
- [98:01]
B
So.
- [98:01]
E
So beyond just building the investment team, we had to build the operations and the risk management around that to be able to facilitate the move. And another element, and probably the third derivative down for us was making sure that all of the organization could move quickly. So our procurement department, for example, that doesn't reside within investments. It's one of our other divisions. And we actually went in and changed legislature so that we could could procure external managers in a streamlined fashion. So if I looked at the public markets, it might have taken us 12, most likely 18 months to run through all the regulations around procurement. And today we can do it within a very flexible, I would say market standard pace, three months, they could do it even less than that. Because we're not beholden. We change the legislature to be able to do that. But in some cases that's what it took. It took us to be able to go out and say, hey, we compete globally for these transactions and we to Move quickly. And so we worked line by line. What were the bottlenecks? Operationally, we didn't bottleneck them all because the list was longer than one might have hoped. But we prioritized it in certain areas. And I think we've become a lot more dynamic as a result of that. But the effort is, frankly, ongoing. Because there's a lot of issues that we face, I think, as a state entity that, for example, they're not facing in Canada or Asia or other areas. And their only sense of competition is speed and scale. And ours like speed and scale. And then we have to make sure that we're in the box with all these other regulations, whatever they might be. And so I think that was a big effort for us to make sure that we were able to move beyond. And we talked a little bit about this framework around costing, and I think that the marketplace and a lot of folks key in on our cost savings. But all of that was just around us trying to justify the increased amount of resources and what we needed to streamline our operations. Because we could easily justify that by saying we might spend $55 million essentially on increased staff and other resources, but we're going to save you 2 billion, and we're going to create over $10 billion in value trying to justify your return on investment. Sometimes to make these types of investments can be tricky and a government level.
- [100:17]
D
If I could add to that, because some might think that the smaller entities have less bureaucracy and. Oh, no, no, we just have different bureaucracies. So we had to go through some of the same challenges, even at our small scale. At OSERS, currently I only have staff of 15. We're small but mighty. But we too had to go to the legislature in Sacramento to get laws changed in order for us to do what we need to do. There was a law in the books from the 1940s for us that we found by accident. Because when you start to change the dynamic of your team, you start to peel the onion back and find some of these things. But there was an arcane law that said all of the Investment employees of OSERS must directly report to the CIA. Can you imagine having 100 people directly report to you and you have a completely horizontal org chart? It just doesn't work. So as we were thinking about our growth trajectory, I mean, we're 25 billion now, but we'll be 50 billion in about 10 years. That's the path we're on. How can you run that with every single employee from top to bottom? Well, there is no top to bottom it's horizontal and everyone needs the CIO and all things have to pass through the cio. So it didn't make effort an any sense. So we started that early and we got that changed now so that we can start training people to be the asset class leaders and the deal makers that they can be. But had we not changed that law, we wouldn't be able to do that with our team. So there's all kinds of these things that you find out that don't make sense in today's world. But I'm sure they made sense in 1950.
- [102:05]
E
Exactly. Some of these regulations were written so long ago and it's hard to change change. It's one of the things maybe we'll end up teaming up on at some point.
- [102:13]
A
Yeah. And even beyond the legislation, as you've highlighted, Scott, I think it just requires a different playbook, this model. Our mutual friend Ash B. Monk, who I know was at the figurative table at least at some point during the Callisters coming of age story with the collaborative model, has talked about the new model needing something like a chief of social capital, basically a queen of networking. Because the web of opportunistic interactions that a collaborative model model creates, as Molly articulated that it begets and begets and begets, is just different than the stereotypical linear GP pitch, GP pitch, GP pitch that I think we all grew up with. So it is a very different organizational design challenge than I think it used to be. So really fun to watch the way you guys are thinking about your personnel and your HR and your talent acquisition too.
- [103:02]
D
Can I add to the tech budget part of the of this? Because the human aspect is going to get either added to or disintermediated by the tech that's coming. And rather than hire a whole bunch of people and then retraining them to be next generation leaders, OSERS is taking a little different vibe and saying let's get all of our repetitive business automated, either using just bots or AI toolkit technology. That way every single person in our organization is now focused on deals, even down to the analyst, because every interaction they make at a conference can be meaningful. And so we've spent the last three years automating everything functionally that happens more than four times a year. If it happens more than four times a year, we shouldn't be doing it with a human anymore. So I think that too changes how you think about staff staffing. But we're on a definite path. We've been using AI tools for quite some time. We've been an early adopter in that format as well.
- [104:07]
A
You bring up AI versus the human, which is maybe an unfair binary tension, but I want to bring up another tension. Scott alluded to this desire goal to be a partner of choice. And much of what I've read, folks that are contemporaries, other CIOs that are pursuing this collaborative model say similar things. They want to be a desirable partner. I think we all want to be sustainable, desirable, desirable, good relationship contributors. But on the other hand, there's an argument, Molly, that some of these consortiums, direct investing, co investing, are frankly designed to circumvent or to go around the traditional GP approach. So how do you balance, how do you calibrate these strong relationships with the reality that you want more control than history?
- [104:52]
D
Well, we want control of our own portfolio. We're not trying to assert control into their businesses model. So we hope, and I think that that's a nuance because some people do say bigger check, more control, you'll take my call first you'll do all these things. I want, I want extra special reporting. I want you to do these extra things. And so what we try to do is say win. Win is so overused. But there are ways where you can both achieve your goals. It is a give and take and there are some compromises along the way way. But it's like a marriage. You have to go into it saying both of us will win. Some days you'll compromise and some days I'll compromise. But we keep propelling ourselves forward and growing. So I think you really have to come in with that mindset that it's not control, it's gosh, I hate to even use the word partnership because that is so overused as well. But it's a new way of speaking to each other other. And it's not everyone sits in their place of I demand X from you, they demand capital and quiet from us and we demand engagement. If you're in it for the right reasons, those things will actually just happen, to be honest. So what are we asking for? We're asking for more communication, we're asking for deeper understanding of what they do and we are asking for them to call us when they have good ideas. I don't think that is a lot to ask for, to be honest. And if we can be, what are they going to get out of this? What is the GP community going to get out of this? They're going to get money put to work without having to syndicate it to people they don't want. So they're Going to get partners that are already partners. They're going to get quick answers from us. I mean, at osers, we respond yes or no, we're in this deal deal within 48 hours and we're finished with our work within seven to 10 days and we have our legal done in less than a week, we can actually execute. So I think that if you show those qualities to the other side, that's what they want. And then we just want optionality and more for our dollar. And I don't think that those sit at odds, to be honest.
- [107:14]
B
Somali, you mentioned very early on in this discussion about, about when you first got into the seat, you did this listening tour with some of the stakeholders, staff, board, all of those kind of things, by the way, for our listeners. Molly was kind enough to invite us to speak with the OSERS board as part of a broader educational series where we talked about tpa. So thank you for that, Molly, first and foremost. But speaking of the board, after you moved into action, how did you bring the board along in this process in terms of basically bringing on more seemingly complex methods to achieve returns? Returns?
- [107:48]
D
Well, we do a lot of education with her board. We have education embedded into every investment committee. Our whole entire board also sits on our investment committee, which is nice that I don't have to do this in one session. And then you've got a group of people who feels like they don't know what is happening. So then you repeat yourself again at the board or you have to do some catch up. So it is nice that our board and our investment committee are the same. So it starts there. But I spend a lot of time trying to sequence the events. So each year we set a goal for one or two things to accomplish and we spend every session methodically talking about the steps it will take us to get to the decision. And then usually when the decision happens, it's like, good, we're done, we're good. Then it just is how much reporting we give back to to them. So we've spent a lot of time building the trust of education first, once we're ready to go, our board has delegated authority to myself and staff and they know we can execute. So we've also built that execution trust already. But we have converted all the old cumbersome manual reports that were so hard to read and all the other things. And a lot of it was verbal and it was text oriented and it's too much. These boards get anywhere from 300 to 500 pages, sometimes in a quarterly deck. No one can possibly digest all of that, nor do we want to write all of it, to be honest with you. So we spent the last two years converting all of that into dashboards through Power Bi and using our toolkit to really narrow in on the most meaningful pieces of data data and spending time in that zone so that everyone feels like they can digest it 1 understand it 2 and then get commentary when we're in session. Honestly, the technology suite behind it has been really powerful to help with understanding, but we do spend a lot of time in education.
- [109:53]
A
Fantastic. We're coming up on time here. So a quick close. I thought you each have talked about a couple examples examples on your own and in the intro segment we listed a whole bunch of others that you were both involved or not involved with. But I'd love for you guys and I'm sure you don't want to talk about specific deals, but more generally as you look out over the next year or two and Scott, maybe I'll start with you and just briefly ask for each of your answers on this. Is there a specific vehicle or approach or structure that you are just excited about exploiting or taking advantage of that is newer to California?
- [110:27]
E
I think maybe I'll just even draw it up a few levels and say that I think the collaborative model we've accelerated. I think we've been fairly successful at instituting that at every divisional level across CalSTRS. And I think that works probably 80% for the vast majority of transactions we do. We delegate authority, we do it at size, we can act nimbly in the marketplace and we've established great partnerships globally. But with the other 20%, I'd say that what we need to do going forward is make dynamic decisions by coordinating the approach across all asset classes and divisions and to do so at scale. And I think that's extremely tough to do because it has another level of internal communication and collaboration that's needed. There's a number of challenges I think that we've identified that we're trying to improve organizationally to facilitate our collaborative model approach and strategy. And if I'd call them out and say Juan is make sure we have the firepower and liquidity to invest invest during crisises or any cycle because again, 44% of our portfolio is now less liquid. We're mature funds, so we're distributing more than we're collecting in. So we've done a lot to enhance our liquidity tools to define a leverage policy to widen our asset allocation bands, to build this systematic approach of asset allocation. And I think that we hurried up to get all that stuff in place. We haven't needed that, of course, over the last couple years, but I think this might be the year where we do utilize that. I don't necessarily believe there'll be a recession, but do I believe there'll be several market corrections? I think so. I think that's actually normal. So I'm suspecting there'll be a few more market drawdowns this year. The second is making sure that we can be nimble not only on a transactional level, but at a divisional level if we see relative value amongst the different divisions. And I think the third is more and more. And in fact, in my career I think I've seen the most today it's what I call mega themes where these are risks and opportunities that affect. Affect all geographies. They affect all sectors, almost every company. Things like climate change or the energy transition, things like AI. And so more and more I have divisions that all want to do the same thing in maybe different ways. So again, it involves us to basically create an approach that goes beyond just being nimble at an asset class level, but we have to be nimble on an organizational level. So I'm really excited about how we're going to define that approach in this next year. And some of that is cultural, getting the teams to communicate more and fostering that. Some of it's structural in terms of the development of our senior management team here and being able to consolidate views across publics and privates. And part of it is just having some more tools around us like I discussed through policy and a center book which we call the Collaborative Strategies Portfolio, which ultimately I think will allow us a lot more flexibility as well. So I'd say holistically, I'm really looking forward to how we accomplish that in next year. And I think this will be the year year where you see us not only be nimble on a divisional level, but nimble on a total organizational level.
- [113:24]
A
It's just fantastic that despite the tremendous progress that has been evident, Scott, that it sounds still like you're in the early innings. So we look forward to hearing more about your journey. Molly, I want to give you the last word here. What is the next P and I article going to be about? What flavor of creative structure are you going to unveil next for us?
- [113:43]
D
I have a few ideas, but I'm not going to give them away. I mean that would be be self defeating. But I will say to Scott's point, on themes, I think there's two Themes that we're watching to see where we want to deploy assets. So one thing is the consolidation of the private credit industry. So we're really trying to figure out what to avoid first and then how can we position our assets so that potentially not only do we get great players in that white space, but if we do this right and get offered revenue share or equity stake in some of these players that are in the fringe parts of the market. What you're seeing right now with the gobbling up of all the asset bias lenders, I wish five years ago when we would been entering that space and we were a large check to small platforms, we would have had the foresight to take an equity stake and now we'd be profiting in two ways. Right. Right now. So there's going to be more of that and we're looking at how can we play that particular part of the market. Scott mentioned the AI theme. We are trying to figure out how we can do that from various different places. Meaning it's an infrastructure play, it's a real estate play, it's an energy play, it's a venture capital play like all of these because you have to have the utility grid to support the the data centers. You have to buy the real estate to build the data center. You have to have the right operator want to use the capacity of the data center. There's all these things. So we're trying to figure out if there's a holistic way to play this. Still tbd, still too early. We're playing all the components separately right now. But it would be interesting to create something that spans different parts of our book.
- [115:36]
A
Fascinating stuff. It sounds like there's a whole lot more to come. Scott, maybe you should give Molly a call on that last one. I think we've just struck a deal right here on Capital Decanted. Molly and Scott, we have a lot of guests on this show, but not only you guys, some of the most admired CIOs in the world. You've been amazing generous friends to Kaya and I just want to thank you personally for that. We are really appreciative of both of you individually and collectively. I know the listeners I speak for when they say we've learned a ton over the last hour. So thanks for being so open and honest and vulnerable with where you're going with this collaborative model and listeners. Stay tuned for the Last Sip. Well, welcome back to the Last Sip. Aaron. Talk about jumping the shark. Jumping to a new dimension. We keep breaking through sound barriers of time. That was Another beast of an episode. But I. I think a lot of fun and very needed as I opened the entire episode. It just is timely. This business is fundamentally changing. The roles that Scott and Molly and their responsibility split their scope of activity is just completely different than what particularly a public pension plan CIO would have done six, seven years ago. So I just found it intellectually so stimulating and exciting and would love to hear what takeaways you you had.
- [116:54]
B
This topic has been really interesting for me to learn a lot more about. My background is more wealth. So I've learned a lot about more of the institutional side and going through this. But even just the sequencing of doing some of this research ahead of time, your background on the front end and then the capstone of hearing how they're putting into practice was great. So I've learned a ton even in the past two hours or so of going through all this. So this was a great episode.
- [117:18]
A
Well, I think too maybe just to double click on that a bit more. I mean, I think the job is just more interesting. Interesting. I don't want to put words in their mouth, but I think most folks in the US Public pension plan CIO seat would say it's largely a political role. And I think they've transformed that in many ways with this new toolkit and tool belt as we described. It's a lot more enjoyable. It's a lot more challenging. I alluded to Ashby's suggestion that you need a chief of social capital. And by the way, if Scott or Molly ever want to hire that, sign me up. You talk about the coolest job ever. Just shake hands and kiss babies and create networks and that's the coolest thing ever. But it is. Joking aside, I do think you need to work out that new muscle because it's really not been necessary in the past. And as you heard from Molly, these discussions create more discussions, which create more discussions and suddenly opportunities start flowing and spilling your way. So it's fascinating stuff.
- [118:13]
B
Yeah. I'd be curious, having done a lot of the background on this and maybe more involved with some of these different asset owners before, was there anything that surprised you or. Or maybe even contradicted what you thought before? I'd be curious.
- [118:27]
A
I don't think so. Earlier in the discussion, there was a lot of focus on the cost and the returns. So I wondered whether some of my suggestions that this was about a whole lot more than just the headline numbers was off or naive. But I think the second half of the discussion, they made clear that what they've learned Again, whether it was initially the motivation, whether it was initially how they pitched it to their board boards or even still how they pitch it to their boards, the reality is there's huge non monetary changes and influences that have bettered them as investment machines and processes. So no, that was the only thing that halfway through I was like, did I miss this one? But I think they circled back much better than I could have articulated, made it very clear that this is multidimensional as far as its outcome.
- [119:12]
B
I picked up on that as well. I was taking notes as they were talking and they both came at it from different angles. So Scott very much on the cost side and Molly much more on the investment side, performance side. But at the end of the day, after they've moved a few years from that initial decision, it's really about both. And they express it in different ways and they approach it differently, but both are very important drivers. It's just what's the thing that gets you started? So I thought that was very interesting as well.
- [119:40]
A
Yeah, that's right. So, listeners, we have a follow up on the last episode. We talked a little bit about holiday traditions, and I can now confirm that both Aaron's brother and my son completed the cinnamon challenge. So there is actually archived video history of this that we will not be sharing. But I just wanted to make sure we close the loop on the chaos and the absolute hilarious nature of those experiences. So I know Aaron's mother is not happy about that, but it happened and it probably will continue to happen if I have anything to say about it.
- [120:13]
B
So, mom, if you're listening, 2025 is going to be awesome.
- [120:18]
A
I think I need to come over to the Filbecks and take part in this. So continuing the holiday theme, just as we are recording this in the early, still part of January in 2025, I'd be curious, Aaron, if you have any New Year's resolutions?
- [120:33]
B
I do. So I actually do a New Year's resolution list every year. I won't go through that laundry list because it's probably way too personal and people listening probably don't care that much. But the one thing that I will say that I have done already is I've removed some social media from my phone. It's about time. So trying to limit some of the distractions that I get caught up in. I used to be a doom scroller on TikTok. I'd lose an hour or two on average a day, which is horrible. And it's so easy just to like pick up your phone and scroll for five minutes here and there. So remove some TikTok from my phone. I don't miss it. It's only been a couple weeks and then a couple other places I've either removed or I've put some settings on my PH to limit my screen time. So I'll let you know how it goes at the end of the year.
- [121:17]
A
Those platforms are designed to hit the dopamine and create the addiction. So that's smart and wise of you. Something we talk about with our adult kids all the time. It is a new world, though. So the boomer in me, or at least they call me a boomer. I'm not a boomer, but sometimes I feel like one in those conversations. Mine is somewhat serious too. So Scott mentioned that his wife doesn't think he's a good listener. I think Scott's wife and my wife have been talking because that has been, let's say, some feedback over the years that has been similar to. And I want to be a really good active listener. I don't think I'm naturally horrible at it, but I wouldn't call it a natural strength either. I read some about active listening and some of the practices and the focus. It really has to be an active choice for the majority of us that this doesn't come natural. If you think about the great politicians, I'm not suggesting either of these folks were great presidents, depending on where you stand. But if you read about Bill Clinton or Ronald Reagan, what people will say is something along the lines of when I was speaking to them, I was the most important person to in the room. The world fades out and they are all in on me. And I want to be that type of leader. I want to be that type of husband, friend, parent, all the above. And I've got some work to do there. My mind spins and spirals and is distracted very easily. So that is actually written down. That wasn't just spontaneous. I wrote that down on the first. So there you go. You can give me live feedback each episode. Aaron.
- [122:38]
B
No, I think that's great and I think very timely. I guess I didn't get a chance to congratulate you, John. Last time we spoke you were just the president, but now you're chief chief. You are the big chief of kaya. So congrats.
- [122:48]
A
12 days in. Yes. Titles. Ho titles. Yes. Well, thank you. I'm thrilled to be in that position. Big shoes to fill with Bill, but excited for what's to come. So listeners, again, happy New Year. Thanks for listening. I hope you learned as much as we did. And we look forward to talking to you again. On the next episode of Capital Decantan. Be well.
- [123:11]
B
Sam.