Speaker 1any good endowment-style investing starts with a good emerging manager program. The general thesis is usually that, hey, I worked at Airbnb, and I think Airbnb will be a big startup factory going forward. And therefore, everybody who spends out of there, who are all my colleagues, I'm going to be able to back them. And that's my angle. That's a great angle. That has worked well over time and very fruitful for a lot of venture investors. The issue and the trick for the folks in our seat is it's got a three-fund shelf life. By the time you finish fund three, everybody you know at Airbnb has left. By fund four, you're talking to strangers.
Speaker 2I'm Ted Seides, and this is Capital Allocators. My guest on today's show is Jay Ripley, Head of Investments and Deputy Managing Partner at Global Endowment Management, or GEM, an endowment-style OCIO overseeing $12 billion. Jay joined GEM in 2014, following six years in private equity, where he developed an analytical and business-based business plan. He's also been a member of the GEM Group, and he's been a member of the GEM Group for over a decade. He's been a member of the GEM Group for over a decade. He's been a member of the GEM Group for over a decade.He's been a member of the GEM Group for over a decade.
Speaker 1of the GEM Group for over a decade. He's been a member financial service. businesses. They would look at a business that originated some form of asset and say, what do I think of the asset quality? What do I think the residual values might look like in that particular industry? Do I want to own the originator, the servicer, some form of service business serving that industry? It really forced you to take a 360 perspective, whether it was aircraft leasing or mortgage origination or wealth management or pick your financial services vertical. It was a lot more complicated and complex than I'm looking at a restaurant and what's the store level EBITDA. In hindsight, financial services is the best launching pad for a future career in investing.
Speaker 2When you realized you reached the peak, how do you then decide to descend off the peak and go somewhere else?
Speaker 1I loved a lot of the things that involved working in private equity. There was a lot of prestige and clamor to it. You were announcing big deals. You were working on important things. At a very young age, I was sitting on boards. My favorite part was I loved working with the owner operators that we partnered with. Stone Point, in particular, had more of a partnership orientation. At that time, they were doing a lot of 51-49 deals where you would approach a founder owner who had grown their business. It was a labor of love for them. Stone Point would say, we're going to buy 51%. You're going to own 49%. We're going to have control, but it's going to be a stalemate. We've got to learn to work with you. We've got to learn to partner with you. In many cases, we were really forced to come to a consensus with the management team in a way that I later learned you wouldn't normally see in private equity. Usually, it's, here's the plan and you can either do it or I'm going to fire you. I worked with a number of owner operators that I admired. I worked with a I thought to myself, I would love to be an owner operator one day. I loved investing. I loved private investing. I loved the craft of it. As I thought about what I wanted to do in the future, the first thing was I wanted to live in the South. I loved living in the Northeast, but I grew up in rural Georgia and she's from North Carolina. We knew we wanted to live back in the South at some point, so that was a long-term goal we had. The second thing was I wanted to be an owner operator myself, but I wanted to be able to invest for the rest of my career. As I was working at Stone Point, we had a group that was doing more wealth management style and as part of it, I was reviewing and talking to the folks that were working on it. I had supported a landscape review of a multifamily office that we had invested in at that time, 2012, I think it was. As part of that, I learned about the OCAO space, firms like Gem. I took note of, oh, they're based in Charlotte and that's an area that over time could be of interest to me, but it's very hard to leave the peak. It's very hard to leave a place where I work with people I admire. I learn something new every day. Stone Point had a lot of success when I was there and has continued to thrive. Just a terrific group of people. I felt like it needed, to be the right opportunity for me to want to move on. How did that opportunity arise? A little bit serendipitously. Stone Point had seeded a hedge fund called Castle Point. It was based in Stone Point's office. I was roommates with one of the senior analysts there and friendly with the portfolio manager, a guy named Todd Combs, who later became quite famous for joining Berkshire. Todd and I were close friends. The Gem team was at a point where they had grown the business from a startup to a more scaled boutique OCAO. They were looking for their next head of equity. I was introduced to them by a mutual friend as I was thinking about Charlotte and Atlanta and all the potential opportunities that might be out there. That team had previously been at Dumac. Dumac were the first LP in Castle Point way back when. They had talked to Todd, who must have said nice things about me. We ultimately engaged in a discussion process. I was a little bit uncertain about going from a GP seat to an LP seat. That felt like something I was still trying to wrap my head around and understand. What ultimately got me excited about though was as I talked to the Gem team, as Matt told you when he was on the podcast, Gem had Thruce and Stephanie and Hugh and the other founders of Gem had made clear that they wanted Gem to remain independent and that they had set up the structure such that folks like me who were coming in would have an opportunity over time to be owner operators ourselves. It wouldn't be under the thumb of some aggregator or private equity overlord. I'd seen that movie before at Stone Point, so I knew what that was like. I saw at long last the opportunity to be an owner operator and to invest for the rest of my career. I was very excited about that. was there in a location that worked well for me. That was what really got me excited about the opportunity. How did you find that transition from GP to LP? At the tail end of my time at Stone Point, we had raised fund six. That was a five or six billion dollar fund. It was a meaningful step up in size. They did a lot of success. As part of that, I was the mid-level investor they would bring to LP meetings to say that I was happy in my job and that we were properly staffed, all the things. They've got to check that box. Probably six months before I left, I was the mid-level investor. I was the mid-level investor. I was the mid-level It was the first time I'd meaningfully engaged with our LPs. I was impressed with their dedication to their missions, the depth of their work. They varied in shapes and sizes and what they were focused on, but they were people that cared deeply about doing a good job for their institutions. I had an abstract version of what an LP did before. I had a loosely positive interpretation of that, but I didn't really know. As I got to know the folks that were serving in that role, it got me more comfortable that this was a role where it would be different in the sense that instead of being in one narrow part of the world where you knew a lot about one thing, you could actually see everything and you could be looking across a much wider swath of things. That was exciting for me. When I moved over, I spent the first six months studying the industry because I didn't know anything about being an LP or what that meant. I was looking at all sorts of data. My then boss, Hugh Wrigley, said, you got to go to every AGM you get invited to. I probably went to, I don't know, 50 of them in the first six months. I tried to consume as much information as I possibly could. There were a few things that surprised me. The first was I knew a lot of folks when I was in private equity who were peers to me. People I compared notes with, traded ideas with. In some cases, StonePoint would, in fact, co-invest with those firms and we'd partner together. I had a pretty good perspective on them as investors. I thought the world of them. I thought these are talented people who are dedicated and smart and hardworking. When I got to Jam and I started looking through the industry data, in many cases, those folks worked at larger firms and their returns were no better than medium. It was surprising to me that my ground level observation is brilliant people, incredibly smart and hardworking and just wonderful folks to deal with. Aggregate level of results that were net to an LP were more in accordance with what you expect from the market. There really weren't the outlier results. There were a lot of firms I had views on where you would know somebody who was a principal and then their peer would leave and start something. They were always talked about as if it would be irresponsible to give them money. Gosh, that sounds really risky. I was surprised as I looked at the industry data to see that in many cases, there was much wider dispersion at that earlier phase of a manager's life cycle, that fund one, fund two type era, but it was dispersion in both ways. Average was better than mid-cap and mid-cap is a little better than large cap. It was pretty clear that I was hired at Jam with the idea that someone who'd been in a GP seat would then know where best to invest as an LP. Part of that was earn strong excess returns. Don't just earn me the market return. I don't need a GP for that. If you wanted to do that, you needed to go early and you needed to back emerging managers. That was a real narrative violation and surprise for me relative to what I would have expected.
Speaker 2I'd love to dive into now sometime later, how you go about that practice. There's a large world potentially of emerging managers.
Speaker 1Where do you start looking? Just taking private equity or what I would call buyout for a minute, just focus on that particular area. A buyout is an apprenticeship business fundamentally. You can't walk in off the street with no credibility or history and complete buyout deals, generally speaking, because you've got to get an investment banker to show you a deal. You've got to get a commercial banker to make a loan to you. You've got to get a seller to agree to go with you kind of thing. There are some real barriers to entry to doing that well. In almost all cases, the folks that create new firms came from prior firms. We think that as a general rule, we need to have an opinion on the firm you came from to have an opinion on you, because almost all the folks that we evaluate on the emerging manager side are a product of wherever their apprenticeship occurred. We are first and foremost always keeping a library and catalog of a variety of different buyout firms to understand the quality of their results, the consistency of their results. What is the underlying nature of their trade? What do they do well fundamentally? Related to that, what would we expect to spin out from them to do well? We're constantly studying the field so that we can have a prepared mind so that if you come to us and say, "Hey, I've spun out of FirmX," we already know about FirmX. We have a rough sense for what the results were, and we have a rough sense for whether we'd be interested in the spin out from FirmX. In many cases, we're trying to identify outlier results, looking for less the super buttoned up, safe, conservative, I don't use leverage, I buy A-plus assets for high-price type folks, and much more the, "This is a deal that investment committee wouldn't always love, but has real upside opportunity, and here's how I can protect my downside." We're generally looking for folks that trained at firms where the investment committee is a little more disciplined. We're generally looking for folks that trained at firms where the investment committee is a little more disciplined. There's more of a culture of asymmetry internally, because if you're trained to the two X gross is acceptable, it's hard to shake that later. That's a tough lesson to unlearn. From there, we have a dedicated investment sourcing team, and they are breakfast, lunch, and dinner out trying to find new spin out ideas. They're talking to a combination of outbound sources. They're talking to former employees at those firms. They talk to a whole bunch of placement agents, head hunters, lawyers, accountants, all sorts of referral sources that are out there. They're also organizing all the inbound flow. Because as we've done this more and more over time, what we've found is those that were the gen one spin outs that we backed, they're on gen three now. They're referring us people who didn't even work at the firm when they left it 10 years ago. Usually what happens is when you're considering leaving your firm and you've decided that's what you want to do, you're going to talk to folks who've already left that organization to understand what their path was. And we found that there is a compounding effect of inbound referrals that have come to us over time as a result of them.
Speaker 2I'm curious in the buyout world of the characteristics, the type of person who leaves, particularly say today when the market backdrop for funds is a challenging fundraising environment. Someone who's smart and good, you would think maybe would look at that landscape and say, yeah, this might not be the right time to do this.
Speaker 1I think they're really coming to shapes and sizes. There's the sort of person who just feels on their bones. And this was always what they were going to do. We meet a lot of sponsors who are like, look, when I joined my prior firm, I told them I was going to leave one day and launch my own thing. But just something that natively, they believe in, they want to do, they have that sort a risk-taking gene. I might argue, while it is interestingly a risk-taking asset class, most people going to private equity are not risk-takers themselves. They chose a conventional career path in a lot of ways. There are less of those people than I would have thought, but they are a large cohort of folks that we see who have said, look, I always knew I wanted to do this, and I got the training I needed, and I did a good job, and I closed the files I needed to at my old firm, and this is what I want to do. We love those folks. We think it's very important when you are leaving a prior firm that you make the leap, that you say, I've turned my email off, I'm now at my house, I don't have a source of income this month. That's a really important thing. When we back any emerging manager, we don't put a bridge or a floor under them because we think that discourages risk-taking behavior. It sets the wrong mindset and doesn't educate them on how hard it's going to be in most cases. The second group, and we're seeing more and more of these today, are the opportunists. Historically, interest rates have gone nowhere but down, multiples have gone nowhere but up. Not that it's been easy, but returns have been pretty consistent in the space for a while. There were a lot of benefits to just hanging out at a place where funds got raised, life was easy. You clipped your coupons. Over time, you stack a pretty meaningful carry if you stick around. That has started to erode post-pandemic, where you've seen that as interest rates have gone up, maybe something you paid 12 or 13 times four with six or seven turns of debt, and you thought, oh, I'm going to earn 2X. Now the debt costs 8, 9, 10%. The deal doesn't pencil anymore. You're seeing a lot of folks that are saying, look, this fund will not raise the fund it did last time. We're going to go from eight partner sheets to five. Maybe my carry is worth half of what I thought it was. We've seen a bigger influx of talented people, but who are doing it for a different reason than we maybe would have seen in 2017 or 2018. There's a related strain of that as the search fund community has become more and more prominent. There are a lot of folks who have graduated from a business school, gone through a search, exited, and are now drifted over into the independent sponsor or some form of traditional private equity market. It's an interesting new channel where we see a lot of folks who tend to be a little younger who come out of that channel and are looking to go a searcher to a true private equity sponsor or private equity firm. I would put them in the opportunistic category as well of someone who's saying, this is a continuation of what I was
Speaker 2already doing. When you and your team have surfaced someone that's come through one of these channels, there's different paths that people take to forming a fund. They're fundless sponsors. There are people who will back deal by deal and get comfortable with someone. How have you decided to approach that space when it comes to making an investment?
Speaker 1When I originally did the fund one, I had the idea that okay, it appears from the data, if we want to earn strong excess returns, targeting emerging managers would make a lot of sense. We presented that as this is an area we want to pursue. We call that our small buyout program. I had a number of folks in mind that I knew from my private equity days that I wanted to see what they were up to in the coming years. We quickly realized that a lot of the folks, when they're leaving their prior firm, they don't jump into a fund one. In many cases, even if the credentials might suggest that they could. The reason I later learned is that when you leave those places, especially when you've on the way out, they say, number one, track record's not yours. Number two, don't talk to our LPs. Number three, here's a bag of money if you sign an agreement agreeing to the first two things. You end up in this interesting situation where someone has worked at a firm for 15 or 20 years. They're running an industry vertical at a multi-industry PE fund, trained, track record, team loyal to them. They've built real credibility. On the way out the door, the firm says, I'm going to hang on to that credibility. You need to go rebuild that on your own. You have a number of people that are trained and very credible that then have to go out on their own and invest deal by deal. It was clear that if we were going to do this well, we had to have some way to engage and support independent sponsors. Because if you think of a buyout investor's career as, I generally think the sweet spot is when you've had 15 years of experience to 25 or 30, so call it mid to late 30s to mid 50s, when you're most productive, most dialed in, most hungry. We were missing four or five years of that, depending on what went on, by not backing these folks as independent sponsors. It's worth observing in buyout unlike in venture or public markets. There's only one source of truth. When you buy control of a company, there's one sponsor, there's a couple LPs, there's a lender and a lawyer. There's not that many people that have a view of what really went on. Any sort of specific actionable insight into what that buy investor did and how they generated those returns are valuable relative to something like venture or public, where when we meet with a venture manager, by the time we meet with you, we've already called the 10 other VCs in the same deal as you to figure out whether you're a good partner and whether you're at any value or how you got access, all that stuff. What we found with buyout, is that if you were going to do that well, and you were going to solve this, consultants have this three-fund track record idea. A lot of that is born out of this idea that fund ones and to some degree fund twos exhibit much wider dispersion. The good ones are amazing and the bad ones are terrible. They'd say, I never want a terrible one and therefore, I'm never going to invest in it. Just show me three funds and then I'll invest with you. We viewed that as the best time to invest with these folks. That's when you could earn the excess returns. You had to have some way to identify and support these sponsors and have a view on what their specific expertise was so you could then support them in a fund one. After we launched the small buyout program, we quickly added on an independent sponsor program. It had a dual mandate. Number one, we wanted to earn strong excess returns in that market. We felt like it was one of the least efficient areas of private equity. There's no such thing as an investment banker who shows an independent sponsor a deal and so every deal is a story deal. The first goal was earn high returns. The second goal though was we felt like the best diligence you could do on a sponsor before they raised a fund one was to make pre-fund co-investments because that would give us the insights to see, the things that matter before you back someone in a blind pool. For example, we've learned over time, willingness to walk away from deals, very important. The independent sponsor format, it is easy to fall in love with an idea. You're halfway through diligence, you get a bad QOV finding, you know that you're going to have some broken deal costs. You would be surprised how often a very credible, thoughtful sponsor is then saying, "I know the QOV says EBITDA is down 20, but it'll be fine. Even at the new price, it's okay." Demonstrating a willingness to walk away from deals, we find it correlates very strongly with long-term success of a sponsor. Quality of sourcing network, quality of how they bring in support value, all very important data points. And then how they handle adversity. In many cases, we've had sponsors who've sold deals for good returns where they thought they got lucky. There was an element of not sure that could be replicated. And we've had other sponsors where the result was pedestrian and we thought, "Man, that was heroic. They did an incredible job." And with a different set of facts and circumstances, they would've done a great job. We found over time that simply having strong returns pre-fund is not a good prerequisite for a fund one. It's about the intangibles we learn about you that support them.
Speaker 2When you compare an independent sponsor going about this, maybe a sole practitioner or a tiny team, compared to a larger shop that they came from, they have less data to analyze a company in an industry relative to history, and fewer resources to then try to add value to the companies. Curious what you've seen with independent sponsors of how they've been able to compete.
Speaker 1I would say for starters, they are targeting a segment of the market where the value creation plan is a little more straightforward. If I go back to my time in private equity, the deals we did in the lower middle market, I was being asked to go to conferences, source deals off market, buy from founder owners for mid single digit EBITDA multiples. And we found there was a lot they hadn't done to grow the business when you got into it. They never looked at buying their nearest competitor. They never looked at expanding capacity, whatever that might mean in their industry. They never looked at pushing a price increase. They never really hired A players within their field. There were a lot of things you could do that would drive value long term that as the market was growing, they were looking for something that would work for them. And if you were a senior professional working on the deal, you felt like you had a lot of agency over generating that return outcome. And then if it had never had an outside owner and you were able to buy it low and grow earnings, you could then sell it to a middle market firm at a very attractive price. The game is more straightforward in a lot of ways in that area. As you get larger and get into the multi-billion dollar fund sizes, it's here's a Goldman auction book with a Bain report and stapled financing. Let's just quarterback this to the finish line. That's a very different game. That's much more driven by the direction of interest rates, the direction of equity markets. Industry selection is very important. Whether you got the, whatever the long-term secular trend was correct. All of the easy stuff has been handled by the prior sponsor. The independent sponsors do themselves a favor, which is that they're focusing on a part of the market, which is hard to secure deals. But once you secure them, they're more straightforward in terms of how you're going to drive value. They, in most cases, don't compete with the larger sponsors unless it's via some form of the larger sponsor as a platform that's doing out on acquisitions and can tuck that specific business in. In most cases, independent sponsors are investing in what I would call story deal. The classic archetype would be a high quality company in the Midwest with a baby boomer owner. Kids have moved to the coast. They don't want to own this thing. And the independent sponsor becomes the son that the founder never had. And they transact at a price that looks compelling relative to what a coastal firm could probably get for that asset. We see a lot of deals like that where the sponsor has some sort of industry nexus. They have some real expertise within a contained vertical. Most of the independent sponsors we back are paired up with an operator they've worked with previously. They often will call us and say, Hey, I have a new deal. And operator X is also going to be supporting us on that deal. And by the way, he's best friends with the owner of this business and knows all about it. There's usually more actionable information that they have relative to you get a William Blair auction book and you get a fireside chat and you've got GLG doing calls for you. I would argue independent sponsors know a lot more about their companies than the traditional large sponsor does about an asset that they have to move quickly in an auction.
Speaker 2They're playing different games in a from the independent sponsor moving to a fund one and beyond.
Speaker 1More and more these days, private equity has become increasingly balkanized. We used to see a lot of folks who were like, I do services or I do industrials. And now someone will often say, I do buy and builds a blue collar services, or it's a transaction type and an industry type as well. They usually are owning some form of swim lane where they think they have differentiated insider expertise. We see a lot of sponsors that, especially the more pedigreed sponsors that come from better firms where they instinctively don't want to paint themselves too narrowly out of the gate. So they come to you and they say, I could do industrials or aerospace or services because I've done all those in my prior firm. And what I always tell them is I would go the other way. I'd go narrow to start and nobody's preventing you on your fund three from investing in some other adjacent market. But out of the gate, there are thousands of you out there. You've got to have some way that you can differentiate yourself. They attract capital, find good deals by picking a couple of narrower swim lanes and really focusing on those first. It allows you to get some early deals done, add some fees to the equation and add additional teammates, which allows you to build toward a fund one as you earn permission over time to widen your box versus starting with a wider box and saying, I might do consumer or industrials or services. In those cases, they do themselves a real disservice because one, it turns folks like us off who say, now I don't know how to define you. And two, it makes the job a lot harder because then you're trying to cover four or five massive markets instead of one. What does it look like when,
Speaker 2something goes wrong?
Speaker 1Within the independent sponsor market, I would bifurcate things into two different groups. There are sponsors who have trained at good firms, intend to dedicate their career to being a private equity sponsor. Hopefully we'll raise a fund one day and view their counterparties as LPs and long-term partners. And so those are the folks that we work with. We're trying to work with the very best independent sponsors and they see us as someone that they want to have a multi-decade relationship with and treat us accordingly. That's going to be a minority of independent sponsors. The majority of independent sponsors are more transactional in nature and quasi deal finders. They've locked up a deal under LOI. They know how to get a deal closed, but they don't know how to run an operated business. They would be much more likely to partner with another private equity fund or maybe a junior capital provider that provides the debt and the equity and bring some operational chops as well, or maybe a family office. You have to bifurcate those two because if you look at our portfolio, when things have gone wrong, we've had deals that haven't been successful. It's looked like we've had deals that haven't been successful. It's looked like a private equity fund situation. They bought a business, earnings went down, they had to rectify that and then sell it. In some cases, it realized a loss. From our perspective, other than having a front row seat to that and having a discussion with them, it didn't feel any different than if a fund two we backed had had an issue. There've been a lot of new entrants in the space and I tell all of them, you've got to be careful because you have to identify the nature of the sponsor you're working with. When we originally launched this program in 2014, there were a number of groups that were trafficking in this area. In a few cases, it was a family office and they'd done a deal with an independent sponsor. The sponsor viewed the carry as a levered option. Once it became clear that the levered option was not going to be in the money, they said, here are the keys, you can run the factory. Now I'm going to go on to my next thing. You have to understand what the risks are within this model and make sure that who you work with and who you partner with really critical. The model is not that different than in a private equity fund context. It's about the sponsor selection process, understanding what game you're trying to play as an LP. Are you somebody who is a direct investor who is putting a press release out and a co-GP on the deal? Or are you somebody who simply wants exposure to an inefficient part of the market and eventually to build a relationship? That's a very important fork in the road. You need to decide up front.
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Speaker 1We always approach this from a place of empathy. We know these folks have put their heart and soul in. It took a lot of courage to leave your prior firm. It was hard to find the deal that you ultimately transacted on. If you're working with someone like us, there was a lot of diligence involved, and so usually we're friendly. We try to be supportive and a thought partner for them. It would be a real red flag for us if they were calling us and saying, hey, my company is struggling. I'm not sure how to handle that. We try to be eyes wide open about the risks they're taking and not letting them shift the narrative on us over time. There are situations where a company is underperforming, they'll bring you an add-on, and we're going to top up some equity because our leverage is not where we want it to be. We want them to be transparent and thoughtful with us about that. Then we want to add capital in situations where that's not going to happen. That makes sense. How much of what's gone on is driven by industry factors versus factors that are underwritable or in your control. In a lot of ways, if things are in your control and you've messed them up to some degree, those are much more fixable by definition. It's harder when an unforeseen third-party issue arises that was a known risk but one you don't control because it's very hard to know when to add capital in those cases because you don't know if that trend will continue. As an exogenous factor, you don't know. They don't have control
Speaker 2of it. I'd love to turn from buyouts to venture capital. Very different market, how have you thought about an approached manager selection in venture capital?
Speaker 1Well, they are cousins on the asset allocators spreadsheet. They are vastly different industries in terms of how they operate. It's power law business. 80-ish percent of the gains come from 15% of the funds. I find that since I started in the industry in 2014, the industry is really bifurcated now into these mega funds that are playing a very different game than the rest of the venture industry is. I'm just going to put those to the side for a minute as a separate issue. In terms of backing emerging managers in venture, most of the folks we see are coming from one of two places. They have been operators themselves working at a well-known tech company, or they are spinning out of some sort of existing investment firm and pursuing the model. If you look over the arc of time, folks coming out of either of those situations have been successful. We will certainly look at and evaluate both. It's worth observing in venture that it looks very different from a life cycle perspective than in buyout because these young people are starting these companies because I think it was Paul Graham who said, the 35-year-old knows too much to ever launch the big hairy audacious company and the 22-year-old doesn't know any better. You tend to see these disruptive companies started by young people. If you look at who funds them, it's people who look like them. A lot of venture managers are in their late 20s, 30s, early 40s. We had a manager recently that we had invested with for over 10 years, a lot of success, very talented individual, and he retired at 45. He said, everybody within my network is no longer relevant to starting new companies. Just hung his cleats up. You would never see a buyout investor say, I'm 45. I'm not relevant. It's just a very different mindset and ecosystem. Within venture though, if I separate those two groups, almost all the new venture launches are going to be early stage focused either on pre-seed or seed strategies, so the very early stages of a company formation. For that first group where someone has worked at a well-known company, the general thesis is usually that, hey, I worked at Airbnb and I think Airbnb will be a big startup factory going forward and therefore everybody spends out of there who are all my colleagues, I'm going to be able to back them. That's my angle. At that point, we're trying to evaluate how these folks build their networks over time such that they can become an enduring firm versus a firm that was centered on some trade or expertise that they had. We're evaluating a number of those folks. In venture, as I mentioned earlier, you have a lot more perspective from others in the industry on the venture investor is or herself. We have more perspective from talking to downstream growth investors, to other investors in the pre-seed round, to the founders themselves, to LPs they worked with who can more consistently benchmark these venture managers and allow us to see. We're evaluating closely as we look at these groups, what does their ownership relative to their fund size look like? Are they willing and able to chase ownership and to buy meaningful ownership in each of the companies? That's a major problem we see that they want a bigger fund size, but they don't want to buy more ownership. That's like saying, hey, I want to start paying 15 times EBITDA for companies, but this company will grow really large and so it'll be okay. At some point, that math will break down. We're trying to study that very closely. It's about the centrality of the network and making sure that we think that they are going to be positioned to see the best deals. For the second group, for the folks who spun out of investment firms, those are more straightforward. They tend to come with a broader, more durable network. What's been tricky about that group is that since 2018, venture vintages have been more pedestrian in nature. Returns have not been what they were in the preceding years. For a while, I remember in 2016, 17, every person you met with was like, I was in the serious seat of Uber and my track record is 42 times money. You're like, okay, great. Where do I sign up? Today, you meet a lot of folks where they're like, I've done 12 deals and I've done a 2.1X gross. That's pretty good relative to the industry writ large over that comparable time period, but it doesn't feel as exciting as it does when you're in that old time period. You can evaluate the nature of their networks and how they're going to win. There's less proof than there was historically. You're trying to dig further to understand. what will make them special, what will differentiate them. And then in many cases, the people who spin out from the larger firms tend to raise larger funds as well. They tend to be more 150 to 400 type range versus the operators tend to do kind of sub 150. At that size, you're also now competing with the mega cap people who are coming down market and they have an army of scouts. They'll do a $10 million check on a hundred, not because they care about the 10, but because they want a right to put a billion dollars in the company later. They can price these things with an algorithm. It doesn't make sense for a two or $300 million fund. We're trying to understand what's the right to win. Why are they going to see things early and why do they have a right to exist? In that power law business,
Speaker 2if you look at those two cohorts of the different origin of the firms that you've backed, because of the power law, you don't necessarily expect the type of persistence and performance that you would in buyouts or at least the consistency of it. What have you found in terms of your ability to triangulate ahead of time and how that's played out with future success?
Speaker 1When I entered the industry, I think it was Steve Kaplan who had the seminal paper showing that venture was the most persistent asset class, that if you were top quartile in a previous vintage, you were likely to be so in the next one. I don't know if this is statistically still true, but anecdotally, I think that the large cap space, that's probably still true. If you're one of the best firms, you'd like to continue to be. In the seed micro realm, I don't think there's a lot of persistence. There is more idiosyncratic lottery ticket type risk in some of these cases, depending on what groups produce spinouts and where you were at that time. What you see a lot of folks do is they write a small check to a fun one. They do a little more in fun too. Fun one turns out to be a little bit more fun. They do a little bit more fun. They a 15X and they had a little bit of money. Well, by fun three, they're like, this is the best thing ever. And they 10X their commitment to the fund. Then that third fund, in a lot of cases, it's not going to replicate what fun one did. And so you end up with a blended return that doesn't look nearly as exciting as what you would have thought on paper. We try to be consistent in how we size these opportunities, recognizing that we don't know which ones will be the best opportunities. We'd want to make sure that they're set up for success, that their ownership to fund size is reasonable, that their hustle and networks continue to grow. And we try to make sure that they need to be top-notch. We're trying to evaluate all of those factors. And then we're benchmarking and scorecarding that against all the other opportunities that are out there. Part of our advantage of trying to say we want to be the first stop for the best talent, just in general, across alternative investments, by having that sourcing team and a robust pipeline is when someone's had early success and is starting, as they naturally do, to grow a larger fund size, but maybe their edge or their networks haven't kept up with that, we can then look at the next fun one opportunity and say, maybe that's more compelling. And we do that across buyout and across venture.
Speaker 2How have you put these together, say both the venture side and the buyout side, into the context of a portfolio or sub-portfolio for your clients?
Speaker 1Both of them fall under the broad equity bucket. So we can get our equity from stocks, we can get it from actively managed equities, from hedge funds, and then from private equity. We view them as, to some degree, distinct betas. You're generally buying control of mature companies where there's a leverage aspect, but they tend to be more predictable over time. If a company's been around for 30 years, probably be around for the next 30 years. If you look at the array of results. If you select well, returns in both have been attractive over time, but buyout has had a much more consistent duration to it, in terms of you tend to have a four and a half to six year duration on average. Whereas in venture, like 21, you're getting distributions every day, and the last two years it's been crickets. And so we tend to have a strong pro-cyclical return stream and distribution stream to it. We do believe that venture has an innovation beta that is somewhat correlated with buyout, but really not that correlated with it. Might argue that today, they actually are a bit at odds with one another. You could argue that AI is going to be a little bit more productive, but that's not necessarily the case. Yeah, I think AI is a much greater threat to the average small business relative to most previous technological innovations. We see a new AI roll up every week where someone's a tech operator and a venture person and a crusty buyout person are going to buy up some legacy industry and then infuse AI. And those may or may not work. I don't have a strong opinion on those, but I will say, you can see now where they're more directly going head to head in a way that they wouldn't have historically. When Matt and Mike and I are talking about where we want to allocate capital, our starting point is always everything in moderation. We want to make sure that we're getting the most out of it. We want to make sure that we don't have strident views that it's zero or one. In most portfolios for our clients, we're 60% buyout, 40% venture, roughly speaking. And that's a recognition that we certainly think we have an edge in both those areas. The liquidity in venture has been shorter over time or longer over time. And in buyout, the results have been more predictable, I think are a great starting point for building an equity portfolio. How do you put together the manager roster in both? We're lifecycle investors. We love doing fun ones. We love doing fun twos. We last year committed to a fund. Three from one of our early independent sponsors. So we've now got data points of going for a long period of time. That was a fund that was north of a billion dollars. So they're getting up there in size. We have some broad categories that we use within the portfolio. So within buyout or private equity, maybe to start there, you've got middle market and large cap, which is going to be higher leverage, higher prices, higher quality companies, more pro cyclical. I might argue more liquid in the sense that if you ever needed to sell those positions, they're more known flow names that you could get out of. I think they have a role in the portfolio and certainly have done well over time. For most portfolios, they've beaten public stocks and generated some form of excess return. You have what we call small buyouts. So that would be those fund one, two, three, the more emerging manager type situations. You're looking for excess returns in that market. That's the sweet spot of that investor's career. When they're 38, they spun out and they've done independent sponsor and then fund one, fund two. We always joke, you can raise money for a long time on good early results. You're never more aligned with a sponsor than you are in that fund one era when they want to have that stamp. Our portfolios are going to be a mix of mid and large cap, small buyouts, and then some independent sponsors as well. We have some loose targets that we use, but part of our model is we don't want to be so prescriptive that we turn off a manager who's gotten a little larger, but we think is better than a new independent sponsor. There is a selection process where we sit down and say, this manager has continued to compound over time. On the venture side, we target what we would call core brands. So those mega cap groups, we've got a number of groups we work with in that area. And then we have our early stage portfolio. In both those portfolios, we also have a target for co-investments and secondaries. It's loosely 20%, although it's meant to be a little bit more of a long term. It's meant to be a little bit more of a long term. It's meant to be bottom up driven. We generally believe that forcing co-invest unnaturally is not a great starting point as a general rule. If you look at most funds, if they have strong results, it's almost always driven by one company. And so the likelihood that one of the 10 was the co-invest is, in my opinion, not very likely statistically. In general, we will do co-invest when they make a lot of sense to do, but we're not hunting for those or forcing those unnaturally within our portfolio. How many different
Speaker 2managers or maybe continuing managers will you have on the emerging side in both buyouts and venture?
Speaker 1We've got 15 approved independent sponsors today. We hope and expect all of those groups will graduate to raise a fund one day. We'll probably back half to two thirds in the fund. In many cases, the reason we won't invest is we've already got two industrial managers or we've already got two healthcare and we simply can't add more to our portfolio. We always maintain a robust pipeline of approved independent sponsors. On the fund manager side, if you think about groups that we've re-upped with, we're generally going to have 15 to 20 managers on kind of an ongoing basis that we anticipate re-upping with. It's a similar amount on the venture side.
Speaker 2I'd love to turn the lens over to the public markets. Have you approached that thought process of investing in earlier managers similarly, differently in the public markets than the private markets? JEM
Speaker 1has a long history of being a day one investor, in particular on the hedge fund side, on the long only side as well, but especially on the hedge fund side. There are good reasons for that, why we've pursued that over time. Some of the benefits that we see, one is you're generally going to get better economics, so there's going to be some form of founder class shares that you can participate in, whether that's a fee or a carry discount or both. Both of those are available. Generally, you're going to be able to shape the conversation on liquidity, which is an important piece to it. You can usually get more favorable liquidity in some form or fashion if you go early. My partner, Sal, jokes that we're caught between the pods who don't seem to care about fees and the endowments who don't seem to care about liquidity. We care about both. We've got to be early to shape that conversation, otherwise it can get away from us. We work hard to make sure that we have a voice at the table, can be a meaningful investor, and can shape that. Having direct access to the portfolio manager over time is an important ingredient that allows us to have conviction as to when you want to add capital. Nobody forgets who backs you early on. We find that as these managers grow, they hire an hour person, suddenly you're being intermediated. You're not getting the same perspective. You're not able to read the temperament of the manager, understand what they're thinking about. It becomes more difficult to add capital, the less information you have. By going early, you're able to see that and benefit from that. The last thing is, it's the optimal point in the cycle. This is the same as buyout period, produce results. Good early returns will allow you to raise money for a long time. The key thing with backing any emerging manager, public or private, is that you want to start with a more modest, reasonable check size, and then you can add money over time. When I was doing my original LP study, I was reading all the seminal texts from Swenson and Klarman and all these folks and was learning a ton about investing and what's worked for institutions and endowments over time. It was clear that the endowments have a long history of going early, but the real superpower of these endowments has been that by seeing people early, they can then identify and add capital to the best ones over time. There tends to be a power law in terms of who they add capital to and who drives those results. Any good endowment-style investing starts with a good emerging manager program, including on the public side.
Speaker 2The hedge fund market in particular has gotten much more concentrated in pod shops. It's just that fee insensitive. They're able to pay talented managers in their style quite a lot of money. Where have you found the emerging hedge fund managers that you wanted to back?
Speaker 1It looks a lot like buyout. We will occasionally see the person who is so passionate about investing, the doctor who managed money on their own and then found outside capital. That will happen on occasion. We've backed some talented people who look like that. In almost all the cases, though, it's an apprenticeship business where you've trained at a good firm. You've been shown what good looks like from a research perspective. Most importantly, from a portfolio management perspective. Some of the portfolio management guidelines, thinking about risk, how to manage your emotions, those are things where usually you have to learn those through observational inputs by working with a PM. I would say it works very similar to buyout in that loosely track and in many cases invest with a number of successful public firms, firms that over time produce spinouts, and if you look at a lot of the day one launches that we've backed, a lot of them are folks who have come out of firms that we had supported previously where we have some perspective on the now new PM, in many cases, what the pros and cons of that person look like.
Speaker 2Within the broad brush of hedge funds, are there particular strategies you've found productive in the emerging manager space more than others?
Speaker 1We do a lot more with day one hedge funds on the long short side versus many parts of what I would describe as the absolute return side, some of the pods, don't really lend themselves to emerging managers. They're really scale games where technology and systems and access are more important. Anything that's a 5 billion pod launch, that's not an emerging manager, that's just a PM who is somewhere else now being on their own. When we say day one launches on the hedge fund side, we're principally talking about long short stock pickers who generally are running concentrated portfolios and have a fundamental perspective on things, sometimes have an activism angle to them. That's going to be the main hunting ground for us on that area. It is usually true that on the absolute return side of the equation, it's one of the few trades that's going to be successful in the long term. It's going to be a lot of competition. It's not going to be a lot of competition. me, people. My hope is that one day we'll be able to process these things even more systematically.
Speaker 2I'd love to circle back to something we talked about early on, which is the owner-operator mentality. Now that you've been in the seat and involved in running the business, you reflect back on that initial mission. Where has being an owner-operator met your expectations and what you wanted to do with your life?
Speaker 1It's been as rewarding as I anticipated. We have over 80 people at GEM, and I feel a great sense of duty to help build and grow the firm so they can be stewards of it in the future. That intrinsic motivation has been as exciting and motivating as I would have anticipated. I have strong views on things and tend to want to move fast on ideas when we want to pursue them. I like the agency of being able to say, hey, this is a new opportunity that we should pursue, and let's go do that. The beauty of having a small independently-owned partnership is that we can quickly come to consensus that it's either a good or bad thing. It's either a good or bad thing. When we do, you have a lot of agency to then go and pursue that. If you step back, in this role, you get to own and run a firm, talk to the smartest people in the world, work with smart colleagues you talk to every day. I can't imagine a better job, honestly. I know I said I thought I was at the peak when I was in my second year at Stone Point, and I loved my role there. I've been somehow even happier in my role at GEM because that sense of ownership and agency has been more fulfilling than I could have managed. To be clear, it comes with a lot of pressure. This is a crosswinds. Obviously, you've talked to other guests about retails coming into parts of our market and consultants doing this. There's all sorts of stuff going on that we have to think about and evaluate and deliver the best service at the lowest cost to our clients, just like any other business. We're constantly evaluating that and how to do that, but it's been rewarding to be able to lead and steward it alongside Stephanie and my other colleagues.
Speaker 2As you look out over the next bunch of years, what does that next peak look like for you?
Speaker 1If you look at the original class of OCAs that was created, most have either pivoted the business, or they've been pivoted. Most have either pivoted the business, or they've been pivoted the model to something else, sold themselves, or both. Going back to when I first joined GEM, I felt like an independent, boutique, research-focused investment operation where you were focused on excellence and having a small number of clients where you delivered high-quality service would be an enduring firm that would always have a role in any market. We have broadened it over time from, I'm a fully discretionary OCIO for small and mid-sized endowments and foundations, to I might be a partner just on parts of the private portfolio, to a $10 billion foundation, or to a family office. We've widened the aperture of how an institution can engage with our research and work with and partner with us. We've added a staff to do that in a way that meets our expectations. I don't know that much needs to change for us. The beauty of not having a private equity overlord or a large asset manager that's pushing you to launch an interval fund or 17 different strategies at one time is that you can focus on the things that you think you do well and where you have an edge. The beauty, going back to the founders of GEM, they have turned the equity over in a way that we don't have to seek an outside partner, which is a powerful differentiator relative to basically everybody else in the market. That allows us to grow at our pace in markets where we think we can do the best work with people that we can treat fairly and compensate well and offer a path to the future. Going back to my Stonepoint days, many of the firms that I admired the most were groups that stuck to their knitting. It could be in a variety. It could be HFF within real estate brokerage or benchmark within venture. Pick your firm. They weren't constantly trying to become something that they weren't previously. At GEM, we have a real opportunity. Hopefully, we'll be larger. We can grow over time our assets, but my hope is that in 15 or 20 years, people still think of us in the same way they do today, which is a group that when the globe has its stamp on something, you feel like the work quality is really high and there was a lot of critical thought that went into it.
Speaker 2Jay, I want to make sure I get a chance to ask you a couple of closing questions before we wrap up. What was your first paid job and what'd you learn from it?
Speaker 1I started working when I was 15. I took two paid jobs. The first was I was a cashier at the local Eckerd Drugs. I was a cashier at the local Eckerd Drugs. I was a cashier at the local Eckerd Drugs, which was, as I learned, a terrible business, later bankrupt, but was a real learning experience for me. I also, living in rural Georgia, was running a little lawn care company as well, where I would mow the lawns. I remember I had one weekend where I worked the morning shift both days at Eckerd and then I was mowing lawns in the afternoon. I got home and I was telling my dad just how tough it was and it was hot and sin in Georgia at the time. He said, yeah, how'd you feel about that? And I said, yeah, it's just tough. I'm not sure if this is what I'd want to do forever. And he's like, good, get your education. So that was an important lesson for me of I know what I don't want to do going forward. And that was an important motivator in the future.
Speaker 2What's your biggest investment pet peeve?
Speaker 1I hear a lot of what I would describe as lazy heuristics that people will throw out. I think they're informed in many cases by some form of business initiative or some form of third party that's saying, hey, you should do X. And they're like, we're going to do X because that's what we're supposed to do. One I've heard a lot recently is we need to co-invest more. I don't necessarily have a problem with that. There are folks who've had really successful co-invest programs. There could be good logic for that. But I've been surprised in many cases that there's an assumption that it's better, maybe because I sat in the GPC for a while and we had a few co-invest that we farmed out the folks when I was my prior firm. In many cases, if you'd step back and say the typical buyout fund has 10 investments in it, if it produces a median return, it's likely that there was a bell curve distribution of deals. We're fine. If it produces an outlier return, it's likely that one deal drove that. If you'd start from a simple basis, the idea that the one of those 10 was the one you co-invested in is not likely. In many cases, the idea that you're going to get fee savings. Okay. I understand that. The idea that maybe you're the biggest LP and we'll get an allocation. Okay. I understand that. We back a lot of these emerging managers. I can tell you they are inundated with offers from folks who are saying, I'll give you a hundred million for your fund one, and I want one-to-one co-invest. What those folks are really saying is I want half off the rack rate and you for you to double your fund size. Obviously, as another LP who's looking at that opportunity, I would tell them, well, don't do that because that would make us a lot less interested. I think there are some real ramifications for folks thinking this is the way and trying to pursue it. We see them distorting parts of markets that are otherwise not good for the industry, large. What's the best
Speaker 2advice you've ever received?
Speaker 1I had a boss early on who'd said 90% of this business is showing up consistently and investing things go well and it feels great and things go poorly and it feels terrible. It feels way worse than when things are great. Part of it for me has always just been, you just got to keep moving forward. As my partner, Matt says, turn the page. It's okay. Getting on to the next one. I just try to show up consistently, keep a long-term orientation of what we're trying to do. And I found that serves me well over time and seeing a lot of folks who have had big rises and big falls. There's an element of stay in the game and just keep moving forward and doing your best work and don't change your stripes as time goes along. That certainly served me well over time. How's your life turned out differently
Speaker 2from how you expected it to?
Speaker 1It's turned out dramatically differently than I expected it to because we were living in Georgia. There was, at the time, what was called the Hope Scholarship. The Hope Scholarship was a scholarship that if you had a B average as a high school student in Georgia, you could go tuition-free to any in-state institution. I think it's called the Zell Miller Scholarship now. At the time, I was playing hoops. I was not a particularly good engaged student. And I remember my parents said, if you don't get a B average at the Hope Scholarship, we're not going to pay. We'll pay for your housing if you get it, but if not, you're on your own. You had to have a 3.0 GPA. I graduated high school with a 3.01. I was as unmotivated as you could possibly be while just clearing the bar. And I remember when I went to school, as I was going through my finance degree, I had some professors that believed in me early. They helped point me in a direction of, you should go in finance. Here's a path that others had pursued that was successful. When I got into banking, you could see that a lot of people had because that was what they were supposed to do, but they didn't really love the game. I remember sitting there thinking, I found my calling. This is exactly what I wanted to do. It's challenging me. It's intellectually interesting. I actually like pressure a lot. It was fun to try to grow and improve. As I look at where I am now versus if you would ask me when I was 16 in Loganville, I am blessed beyond what I could have ever imagined at that time. And I'd feel lucky every day to be able to show up and work with my colleagues.
Speaker 2All right, Jay, last one. What life lesson have you learned that you wish you knew a lot earlier in life? The big thing for
Speaker 1me is you can just do things. The world will bend to your will in a way that you wouldn't expect. If you have a viewpoint or if you have a way the world you think should pursue, I think the best example is when I came to GEM, I was like, look, I don't think we should be committing to large funds. We should be chasing independent sponsors. That seemed crazy, to be honest. God bless my partners for agreeing to go along with it. With hindsight, I was that young founder and I didn't know any better. It just felt like, oh, it seems like what you should do. And I think now seeing how that industry has evolved and grown and there's a lot of interest in it, it's become clear if you have an insight and you think the world should operate and it will bend to your will. I found it to be really enjoyable and we've grown a lot at GEM on the back of that. Jay, thanks so much for
Speaker 2sharing these great insights on manager selection. Thanks for having me, Ted. Thanks for listening to the show. If you like what you heard, hop on our website at capitalallocators.com where you can access past shows, join our mailing list and sign up for premium content. Have a good one and see you next time.
Speaker 3All opinions expressed by Ted and podcast guests are solely their own opinions and do not reflect the opinion of capital allocators or their firms. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of capital allocators or podcast guests may maintain positions and securities discussed on this podcast.
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