E166: $20 Billion CIO:  Why Small Cap Stocks Have Underperformed  (and why that’s unlikely to change) w/Brad Conger

even though I have the greatest manager, I'm asking them to do the wrong thing.

Today, I'm joined by Brad Conger, the CIO of Herdung Callahan, an outsourced CIO managing roughly $20 billion.

On today's episode, Brad discusses why he believes the small cap index has fundamentally changed and how the rise of private equity has impacted the public markets.

Brad shares his insights on balancing portfolios in this new economic environment, the virtue of illiquidity, and common investment mistakes.

We'll also explore his contrarian bet on Europe and how a strong investment thesis can help weather even the most difficult of market fluctuations.

Without further ado, here's my conversation with Brad.

Eugene Fama famously won the Nobel Prize for his three-factor model, which showed that small and value stocks had outperformed for many decades.

You believe that may not be the case today.

Why?

The small cap

index has fundamentally changed in its composition since those numbers, the numbers that were used in that study.

And so, for example, the small cap index now,

I believe, is much lower quality.

It used to be companies transitioning from small to large.

There were also companies, fallen angels, so large that had fallen on hard times.

And then there were permanent residents, meaning sort of companies that just trundled along and never really grew.

I think

those last two baskets of small cap have increased dramatically.

And the reason is that I think the PE industry, by keeping companies under advisement longer, has truncated the ability of the small cap index to capture growth in entrepreneurial capitalism at an earlier stage.

And so I think those numbers were, you know, fine as they were computed.

I think that the index has changed over time.

So historically, the small cap were just smaller, higher-growth companies, similar to the large cap companies.

Today, they're just fundamentally different businesses.

They're fundamentally adversely selected.

Double-click on the types of small cap companies that you see in the market today, 2025.

There's a meme out there that something like 40% of the Russell 2000 companies have an EBIT less than their interest expense.

In other words, they're zombie companies.

I don't know if that number is really true or not, but it's clear that the default risk, the bankruptcy risk in small cap stocks has dramatically escalated.

The debt to equity is much higher than it has been historically.

So I think that is

one of the consequences of this, you know, PE taking the growth out of the public markets.

To double-click on that, not only do you have these companies that are poorly capitalized, but the good companies are staying private.

So it's not only that there's bad companies that are public, it's also the good companies are not going private.

It's two different factors that are affecting the small business.

So Klarna, when it comes out, will be a $40 billion company.

I would assert that 20 years ago, 15 years ago, Klarna would have been an IPO and it would have been IPO'd in the small cap zone, something less than $10 billion.

It's leapfrogging that whole class of companies and it's going straight to, it'll be in the SP index within six months.

And this phenomenon is not only going on with private equity companies, it's also going on.

Klarna is also venture-backed.

So the quality of small public companies on both potential PE targets and VC targets is also lower quality than it would be before.

In other words, companies are just staying private longer in both PE and venture.

Absolutely.

It's more attractive for managements to basically work for KKR and live in that ecosystem where they can graduate to larger portfolio companies over time.

They don't have to worry about the public communication.

So yes, I think that, you know, not to disparage small caps unnecessarily, but I think it's comprised more of companies that have to be there rather than companies that want to be there.

The companies that have a choice, you know, stay in the PE ecosystem longer.

As a CIO of Hurdle Callahan, you have to now balance portfolios for your clients with this new paradigm.

Does that mean that you're investing more into privates, like private equity and venture capital, just to keep it diversified?

How do you adjust to this new reality?

Number one, it's a slightly different

sort of starting universe.

In other words, they're 150,000 companies below 50 million in EBITDA in the U.S.

So you have

a different,

if you will, and perhaps diversifying subset of companies there.

That's one.

The second is that

the managements have more incentive make their companies more valuable, more levers to pull in the private market, more patience.

And so

our case for private equity is more alpha-driven than a belief about sort of the market cap weight of

private versus public.

One of the ways that I look at this part of the market is a lot of people look at it from this paradigm of, should I add more privates?

And there's this very long tail of individuals, high net worth, RIAs that are entering the asset class.

Another way to look at it is: if I don't have exposure to the private markets, if I don't have exposure to venture, if I don't have exposure to private equity, am I actually doing a disservice in that I'm not only not being cutting edge, but I'm actually not perfectly diversifying my client's portfolio.

Both.

So, as I said, I think that the market, for example, for venture growth-backed companies,

now that they are staying private much longer through much longer stages of their life cycle,

you are missing those companies that would have been available to you in the public markets.

So, for sure,

you're missing an opportunity.

But as I said, I think the

alpha opportunity may not be 500 basis points over the public markets, but even if it, and we model something like 150 or 200 over for private equity

buyout companies.

If that's the case, it still makes sense.

You know, if you have that illiquidity

available to you, then why forego 150, 200 basis points of alpha?

One of the themes I'm really exploring on the podcast is the virtue of illiquidity, how illiquidity keeps people from making mistakes, how it takes away the temptation to sell.

People debate this and say, no,

I'm going to hold my assets.

I'm a disciplined investor.

Just a couple of weeks ago, we saw with the whole tariff week where it went down and went up, both kind of historic top 10 swings.

Talk to me about the virtue of illiquidity.

And have you found illiquidity to actually be a benefit to your clients' portfolios?

I completely understand the argument, and I do believe it a little bit.

That if you have an allocation to private markets,

you're not fooled by the stale marks in your portfolio.

You know, you know, in the past two weeks that your companies took a hit, but I think emotionally it's much more,

you know, it's much more productive mentally to have your hands sort of tied.

So I think that's an issue.

However, I would say our clients, one of our roles is to make sure clients are in the right asset allocation.

So regardless of whether they have, you know, 50% of their equities in private equity or zero.

Our job is to fight those sort of irrational temptations when markets sell off and people get emotional.

So I don't discount that as the illiquidity,

the value of illiquidity

as sort of an important

guardrail.

It's just for our clients, we think we're providing that service either way.

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You see a bad practice in how LP consultants advise their clients on their asset allocation.

Tell me about that.

I look at a lot of prospect portfolios in competition, and I think

two sort of vices that I see is one, there's a fetish with alpha.

In other words, if I put together a portfolio of great managers, star athletes, I can just throw them together and that will work.

And the fallacy of that is I can, and we see this all the time, I can have the best biocap manager in the world.

And over the past 10 years, biocap has underperformed the SP, the cost of capital, for by

500, 700 basis points.

So even though I have the greatest manager, I'm asking them to do the wrong thing.

It's sort of like I hire Roger Federer and I put him in a ping pong tournament.

I'm sure he's good at ping-pong, but I'm pretty sure he's going to get killed.

So I think the first

problem with institutional portfolios is that people are

so obsessed with alpha and thinking that that will solve all of their problems that they're less discerning about the bets they're making.

So I made a bet on biocap.

Was I aware of that?

And you see that with there's a predilection for value managers and small cap managers and REITs and real assets.

And all of those things are great, but

they really have to beat the opportunity cost.

And look, it's true in the past 10 years, that opportunity cost has been steep.

In other words, the SP has done 15.

And it's very hard to beat that.

So maybe I'm over-anchored on the past, but

it has been costly.

The second

problem in institutional portfolios, and it's similar, but it's the belief that asset classes are entitled to a return for all time based on what they've done in the past.

So an easy example is REITs.

You know, for 30 years from 1990

to 2015, odd, REITs had fantastic performance.

They had growth.

They had yield.

It was a great space to be.

That turned in about 2011, 2012.

The shopping center crisis, you know, the crisis of malls

sort of hit, and then subsequently, office in 2020 with COVID.

And so I think that it was a strategic allocation that people believed had an entitlement to work at all points in time.

And that overlooks that asset classes change, just like we discussed with small caps.

Asset classes change what they are.

And so what they can do for your portfolio is always changing.

So, both number one, the alpha, I call it the alpha fetish,

and secondly, this strategic positioning that's based on backward-looking track records.

Just to play as a devil's advocate, capital markets presumably are efficient.

So there's not necessarily a time that's better to invest in biotech or not, because that would be reflected in the prices.

So if a lot of people aren't bullish on biotech, the price would go down and the entry price would be lower.

All the pricing should be more or less at an efficient time.

Why not just try to get the best athletes in the different spaces and take this kind of passive approach in that you don't know if the next decade will be the decade of biotech.

Talk to me about how to make the best decisions before placing a bet.

Absolutely true.

And the humble starting point is to say, I don't know, right?

And assets are efficient.

And if that is your, and that's the right outlook, then you should have all of those positions.

The neutral position should be the market cap weight.

And what we see are positions in small, in REITs, in real assets that are vastly out of proportion to their market cap weighting.

So, for example, you know, energy and REITs are two areas.

And it's based on this belief that the

world will always land in one of four quadrants, you know, high growth, high inflation, low growth, low inflation, and the two diagonals.

And therefore, real assets play this important role in high inflationary environments.

And so I understand the theory.

I just question that

if you were truly humble and you were truly neutral, then you would be market cap weighted.

And that's not what we see in portfolios.

And why is that?

You know,

people look, you know, people extrapolate on a straight line basis.

And those are asset classes that worked at points in time.

So if you look at

small cap between 2000 and about 2011, 2012, it outperformed.

Maybe it was the starting point, you know, coming out of the TMT bubble, lots of deeply discounted low-value stocks.

But the portfolios that have been constructed in the last decade, I think, over anchor on that decade of outperformance, and they've suffered from it.

It was a bet that that performance would continue.

And no matter how many times it's said about past performance not being indicative of future performance, we still see behaviors that are predicated on that tenet.

Presumably, there are quality small cap names.

How do you find the quality in the small cap space?

So, we construct oftentimes tilted portfolios

starting with the index and then tilt it towards characteristics that we like.

So, for example, in the past 12 months to 18 months, we've had a bias to defensive growth stocks in the U.S.

So, names like Berkshire Hathaway and Visa, MasterCard, the rating agencies, Moody's and Standard and Poor's.

And so I actually think that makes a lot of sense.

You start with an index, you decide what you like to own, what you're comfortable with, and what you think is truly well-valued.

And then you run a screen to sort of select those companies.

And I think that's possible in small caps.

We have done a lot of work on UK and European small caps with

philosophy in mind.

So you mentioned Europe.

You've really leaned into Europe over the last part of several years.

Tell me about the thesis on Europe.

Going back to the invasion of Ukraine, we underweight Europe in favor of the U.S.

So from 22 to early 24, we were underweight Europe because we believed the energy crisis, the Ukraine invasion would sort of dampen sentiment and raise costs for businesses.

So we were overweight the U.S.

In about the second quarter of 24, we went overweight Europe based on the valuation discrepancy.

So normally Europe trades at something like a two to three multiple point discount to on forward earnings multiples to US stocks.

Fine.

U.S.

stocks have better growth, better corporate governance.

So that's the sort of 15-year average.

And at the time, they were trading on something like

seven multiple points discount.

And so we felt that was an excessive, excessive discount.

And we put about five percentage points of our U.S.

portfolio, we shifted it into Europe.

And that was very painful because that discount went from seven to eight and a half by the end of 24.

And I mean, it was a very painful period, but we kept looking at the characteristics of the companies we owned in Europe.

And we felt comfortable that

we weren't bearing a sort of existential risk.

And so we kept with it.

This quarter, they're up 20 points relative to the U.S.

So it's paid off.

And in fact, start to finish, it's been a good decision.

So happy with that.

Double-click on that, on taking a contrarian directional bet.

How does that play out internally?

How does that play out with your clients?

And how do you execute on that effectively?

Obviously, it's very difficult because you're going against the prevailing wisdom and you're going against performance.

So you're doing something that makes people uncomfortable.

And so our approach is: let's lay out our investment thesis with as much detail as we can.

And so we looked at the composition of those two markets.

We tried to explain that even though there's less tech in Europe,

there's still even adjusting for that, there's still a discount.

We looked at the growth rates.

Even on growth rates, the PE to growth for the US was more expensive than Europe.

And so we just, I think we just brought

a plethora of data points to support the thesis.

But you're alluding to this, it only can go so far.

When you lose money in a position that people sort of are hesitant about,

the pain is double.

So

it's a constant communication.

And by the way, we're doing that as investors.

That's our job to constantly re-underwrite new information,

what should have changed about the original thesis.

And luckily, we didn't lose our nerve because we couldn't find anything that was really terminal about Europe.

I think one of the most underrated aspects about having a strong thesis is it creates a strong position to be able to weather different market fluctuations.

The joke is a lot of people ask what stock to buy.

They never ask when should I sell.

So if they only know that they should buy something the moment it goes down, maybe there's some noise in the market, they're going to sell.

So I think a lot of people would benefit more from having more conviction to why they're doing something and building their conviction.

Conviction is not binary,

it's on a scale of like, why do I believe in this?

Talking to more people.

That's the way, that's the proactive way to really weather storm.

It's very difficult to say, you know, when the storm comes, like, hold on tight.

It's easier to say, build conviction, you know, build the strong tree trunk so that when the storm comes, you can basically weather it more easily.

David, that reminds me of something Warren Buffett tells people all the time: is when you leave college, you should have a punch card of 20 punches, and that's all the investments you'll get to make.

And the implication is that if you know that you only have 20 decisions to make of your investing career, you'll think very, you'll build that conviction.

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So, you guys are fully discretionary, so you're able to invest on behalf of your clients.

How does that change your ability to navigate markets?

I tell you, it's a wonderful liberty because what it allows us to do is look at the whole spectrum of asset classes around the world and say, what is the best risk return?

So, you, as the client, give us a total return target,

and that implies a total risk.

And then you give us an active risk budget.

So, how much can we deviate around your policy target?

And so, that allows us really to make trade-offs between asset classes that are, for the most part, fungible.

So, for example, in 2018, we zeroed out junk bonds in our portfolio.

And the

view was that when the spread of the double B bond on the triple B bond index got below 100, it was inadequate compensation for the likely full-cycle default risk of junk bonds.

So we zeroed it out.

But importantly, we didn't de-risk clients.

We just took the risk that was in high-yield bonds and we redeployed it into equities and fixed income, meaning to reflect that high yield bonds are really a hybrid.

You know, in bad times, they look like equity.

In good times, they sort of look like corporate credit.

And so that's the kind of flexible decision making that we have as OCIOs

that, you know, people who are working under much more constrained asset class limits don't have.

One of the sexiest topics of asset management is corporate governance.

I remember in undergrad business school, I thought it was the most boring topic ever, but it seems to be the one that's really driving returns.

There's a couple of famous studies.

There's a Center for Retirement Research as Boston College 2019 study that showed that public board composition impacts returns.

There's another one in 2024

based on in the Journal of Information Economics.

on this whole concept of the importance of corporate governance.

And

it's an interesting thing, but it's intuitive in that if you give people more degrees of freedom, if you don't lock their arms up and if you don't tie up their arms, they're able to make better decisions.

And our clients can terminate us on a day's notice.

And so we're very clear, you know, with the risk that we take on their behalf.

And hopefully, when we engage a client, they trust, they see enough of themselves in our decision-making process that we get an extra degree of freedom.

But obviously, you know, sometimes clients, you know, have over time have a fundamental disagreement with your investment process.

And it's incumbent on us to sort of make the case.

But ultimately, they're the CEOs, so they choose.

It reminds me of a famous board member once told me that up until the time that I replace a CEO, it's the CEO of the company.

We have to do what he or she says.

And And then the next day, if we replace him, that's when we make the decision.

So you have to give people the rope to do their job until you decide to ax them, and then you can move on.

But this whole thing about not interfering with the manager that you've hired.

And the best boards we have

are ones that operate on that principle.

And

one that stands out was a professional sports organization.

And they were very competitive people

and extremely tough, but they gave us a lot of freedom, maybe like

how you would work with a coach or a general manager.

In other words, they would say to us,

we don't agree with you.

We would tell them we're doing something like cutting high yield bonds.

And they say, we don't agree with you, but that's on you.

We wish you the best.

And I love boards that really have a bright line of their role and our role.

Their role is to give us marching orders, like I said, volatility target, tracking error, illiquidity,

but then

give us the right to make decisions and hold us accountable for them.

That's on your level as an RIA.

Let's go down one level.

below to general partner.

Let's say that a general partner saw this opportunity in Europe.

You talked to me about the leeway that you would give a GP in a specific strategy.

We give them

complete leeway consistent with the strategy they've articulated.

So we do have managers that have that right to go flexibly across borders.

In that case, if we found the managers taking positions which were overlapping with ours and creating more risk than we wanted, we absolutely overlay that.

We do that.

We reverse that decision for our clients.

And we do that all the time.

We just had a manager in our program

and

they're a technology growth type manager and they went to 25% cash in mid-December.

They just said, we don't see anything.

Now that ended up with hindsight being roughly the right decision because markets peaked there or in mid-February.

But we were not comfortable giving our clients that cash drag.

So we overlaid it.

This opportunity that you executed in Europe recently, is that opportunity still present today?

The valuation case is close to where it was when we started.

So I told you we were seven multiple points different.

Right now, we're about six.

In other words, the U.S.

market is about 20 and a half times forward earnings.

Europe is about 14.

What's changed for our case is that you've now had probably the most remarkable unexpected stimulus package by a European country in the post-war era.

So, Germany's stimulus they announced at the end of February

has, I think, set a new bar for what other European countries can do and are willing to do.

So, the sentiment has changed for Europe, and therefore, the momentum has changed.

At the same time, there have been more questions about the U.S.

because of tariffs and even U.S.

earnings.

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The consumer confidence is rolling over.

A lot of the survey data of corporate spending intentions has rolled over.

So it's working on both sides of the trade.

So I actually believe that it's more

advised or more powerful an argument now than it was 12 months ago when the pure valuation argument was a little bit stronger.

You mentioned tariffs.

Walk me through how an organization like yours navigates a difficult situation like that.

So, tariffs hit on Monday.

What do you do?

Talk to me through strategy, communication.

So, we came into the

turbulence well positioned.

So, we had a defensive bias in U.S.

equities.

We were underweight the Mag 7.

We had an overweight to defensive growth names in the U.S.

We had Europe,

which Buffered performed better than the U.S.

did.

So we felt like, in a sense, we were positioned for a more turbulent environment, and we got it.

As a result, we did take, we used the opportunity to actually harvest some of our insurance.

So we sold all our defensive equities, went back to the benchmark.

So implicitly, we bought more of mega cap tech, which we have been nervous about.

So

one result was we sort of repositioned the portfolio pro-risk.

The second thing we did was we started writing out-of-the-money options on the SP because we're natural rebalancers for our clients.

So, you know, cedaris paribus, all else equal,

when equities go down, we are going to be inclined to rebalance.

So if they underperform fixed income, clients become progressively underweight relative to their targets.

So we are a natural buyer of equities.

So we wrote put contracts out in May, June, July at levels something like 10%, 15%, and 25%

below the market with the knowledge that that committed us to buying the market down at those levels.

We got paid exorbitant amounts of premium because VIX went, we started doing it when VIX was 25, and we did it all the way to 50.

The answer to your question is: I think we leaned in to the risk.

We were well-positioned going in.

We harvested some insurance, and then we leaned in to the risk-off environment.

We'll see whether, look, there's no guarantees that this could get worse.

I think

in the conversation with clients,

these occurrences are normal and they happen every five to ten years when there's a complete reset of expectations.

So, from you know, perpetual 3% GDP growth in the U.S.

and 10% earnings growth to something that is more normal.

Our view, we tend to be, we want to be long-term investors.

So, when markets sell off, we tend to be buyers.

Unpack one of these put trades that you made in May and June.

So, give me one example and how that functions in your portfolio.

So,

we would write something like a July 3,600 put on the SP when the SP is trading at back two weeks ago or a week and a half ago, something like $4,800.

So we're writing a put that's 25% out of the money.

But because

normally that put

doesn't earn you much money, doesn't earn you much premium.

At the time, I think it paid $130.

So we were getting paid 3% premium for

two and a half months

to

pre-commit to a trade that we would do anyway.

You know, in all likelihood, if the SP goes to 3,600, we're going to buy stocks because our clients are going to be underweight.

Obviously, if the SP goes to 3,600, there will be a new circumstance.

You know, it will be China will have invaded Taiwan.

That's why I'm careful to say,

you know, in most circumstances, we would be buyers of stocks.

And I think that when the volatility market is pricing things at extremes, you need to take advantage of it.

I'm curious, that put, is it always executed at that price?

Or if it falls below that, you get it at the lower price.

You own it at $3,600.

Right.

So as the market moves there, your delta or your equivalent exposure to the market keeps rising.

Right.

And at expiration, at the strike price, you're basically at a 50 delta.

You own that.

You own the market at 3,600, which is fine with us.

And by the way, we've got these staggered out at different tenors and at different levels so that we're not going to be overwhelmed with a position at one level at one point in time.

So this is next level.

This is not about holding steady in a difficult market.

You're saying that while there's panic in the streets, I'm going to be able to risk get that risk premium.

And I'm getting paid to take the right action when things go badly.

So, not only am I not doing the wrong action today, and not only am I preparing myself to take the right action if things happen, I'm actually getting paid to box in my thinking in a way when things go really bad.

So, you're taking away your optionality, which is actually hurting you and monetizing that.

Yes.

And look, if things go pear-shaped, like there's a

conflagration in the Middle East, Israel attacks Iran.

That is our risk.

We actually have pre-committed to something based in a normal world.

But we're prepared to and we're doing this in a moderate way.

So we're talking about risking

two and a half, 3% of the portfolio, meaning committing ourselves to buying 3% percent of equities.

By the way, if the market is there, we're going to be five percent underweight equities.

In some ways, you have to do that, anyways, just to rebalance your portfolio, whether it's difficult or easy to do so.

We think we're getting paid to do something we do anyway.

When we last chatted, you mentioned that you're still bullish on big private equity funds, that they could still have really great returns.

Why do you believe that big private equity funds can still work?

Look, it is a completely empirical argument.

So, our experience has been been

we've always had a mix of emerging managers, spin-offs from bigger firms,

but we've always found

a lot to like in the bigger firms.

You know, Bain, for example, is a big holding in our portfolio.

And you get all that comes with that, which is deep resources, lots of practitioners, lots of knowledge across

many sectors of the market.

And I think that's the trade-off with the size.

In other words, yes, they're much bigger.

They have to deploy, they have to write a lot more checks.

They have to do bigger deals, probably more competitive deals.

But they've also developed the expertise internally, deep

skills to do that.

And so there's a fine balance.

And I'll tell you, we've found that when we exited a manager because they were too big, invariably it has turned out to be the wrong decision.

In other words, those firms have kept performing in line with what they did at smaller levels.

Now, that's not statistical proof for you, but it has been our experience that you don't discard managers because they're large.

So, that intuition of cycling out of a manager as it gets bigger has not served you right.

Looking back at it, just analyzing why the fund continued to perform well, why do you believe that is?

What are the factors that was driving it to continue its outperformance?

Firms that stick to their knitting and build their capabilities and keep the same talent over cycles

actually execute more effectively.

Let me put it this way.

They can execute more effectively at scale than newer entrants where the principles are sort of melding together and they're learning how they react to different circumstances.

Whereas, what you see at the big firms is

they have very honed sort of teams and processes for handling every situation.

Meaning, when this happens, we do this.

You know, when a company goes off the rails, here are the steps we take.

So, if I had to say one thing, I think it's that their process and their people are tuned every possible situation.

And so that overcomes the disadvantage of scale.

So, presumably, when you have that amount of capital, you're slightly overpaying for the same assets, but you're saying you're minimizing your error rate because you have processes, you have a brand advantage, so you're able to get maybe higher sale on the exit.

You're able to have the right playbooks, the right talent.

So, those things are actually more powerful than the slight or maybe even high overpayment on the assets.

Those are the two factors, right?

I think so, exactly.

So you underestimated the competitive, then come in advantage, or you overestimated the

higher price.

The friction of scale, yeah.

And now that could change in a different environment,

but that's been the experience over the past five years.

you know many of the firms that were strong at you know a five billion dollar fund got stronger in their ten billion fund, maintained it at $15 billion.

So

I think it's a trap to assume that the returns are necessarily going to degrade.

Conversely, the firms that have not been able to retain talent, that have not created processes, that have not created moats, have suffered.

Correct.

And luckily, we haven't had that experience.

We've definitely had firms that we believe overreached relative to the opportunity set, meaning they raised

a $10 billion venture fund, and it's just mathematically very challenging to get five to 10 X's

at that size.

Not impossible, right?

It can happen, but I think where we've

exited, we've had a belief that there were severe challenges.

And the contrast is when firms are doing writing, say, $300 million checks, the challenge to go to a $600 million check just in buyouts, it's just not, it's not as severe a hindrance as in venture going from a $10 million check to a $300 million.

My thesis would be one of the reasons that they continue to perform is maybe the same ambition that led them to $5 or $10 billion, this long-term greed, is also keeping them from being short-term greedy on getting too big.

So the same thing that made them so competent, good at recruiting, building long-term organizations, is also the same thing that's keeping them from being seduced by growing for growth's sake.

Yeah.

The other thing I'd point out is: I think these larger organizations,

and obviously, there's a selection bias.

The ones that are large are also successful, right?

But I think they're very good at transitioning GP ownership down through the ranks.

So, you know, the founder who started the firm 40 years ago has become a billionaire and sort of slowly transitions out of the firm.

And he's passed it to, you know, the next generation.

They've become 100 millionaires.

They're happy to take less incentive.

So they've become very adept at managing

the movement of ownership to the right level of responsibility.

And it's sort of, I know it sounds sort of altruistic that a billionaire is not, is less greedy than a 500 millionaire, but I think that's characteristic of these firms.

Also,

this isn't happening in a vacuum.

They're looking at other firms from previous generations that have gotten big, that didn't have generational planning, and they're starting to evolve with the market itself.

Yep.

How do you know ahead of time you're diligencing a manager?

And how do you know ahead of time whether there'll be a manager that'll deal with generational planning effectively and generational transfer effectively?

So, when we cover a GP, we spend a lot of time at all layers of the management company.

And so, obviously, we're talking to the people who run the portfolio.

But when we go to annual meetings, AGMs, we're trying to build relationships all the way from

MD down to senior associate.

And we're getting both an understanding of the people, meaning the depth of the bench, but also the attitudes about ownership.

In other words, you know, how motivated is the third year vice president

for this fund.

And

so with the good firms, you see a very consistent level of excitement and motivation.

Even if somebody's doing, you know, data gathering as a fourth-year associate,

they are as excited about the fund, the current fund, as the MD who's going to take home, you know, five points.

Sometimes the newer generation, the money is much more life-transforming to them.

So they get even more excited than the people with hundreds of millions of dollars.

Taking a step back, how do you build out your private equity portfolio?

And tell me about the principles.

So it's a little bit top-down and a little bit bottom-up.

The top-down guardrails are: we want to create a portfolio that is over time about 40% venture and 60% buyout growth equity.

We also want to have a geographic diversification.

So we want to have some Europe.

We want to have some Asia.

We want to have,

you know, a big piece of it in the U.S.

We want to have some Latin America.

So those are the only guardrails at the top-down level.

And then everything is case by case.

Obviously, we have a roster of managers we've worked with over several funds,

And

we're constantly recommitting, reevaluating, recommitting to those managers.

But we're sourcing

a lot of

new management companies that have spun out of our existing relationships.

And so I would say mostly

it is

a bottom-up selection process.

It's very driven by networks that you create.

And I know that sounds sort of haphazard, but the truth is,

you know, we've partnered, we've had great experience partnering with firms or principals that have spun out of firms we've known.

They've started new funds

because we knew their process when they were back at their old firm.

So it is very much a

networking driven selection process.

Why do you like spin outs and why do you have a bias for spin outs?

Let's say they're firms firms that we love.

We love the niche that they're targeting, the skills that they bring to the business.

It could be operational,

for example.

And

what you see sometimes is that there are rising stars, principals who just who become, you know, who run a fund over a couple of iterations, and then they just decide they want to run their own show.

And maybe it's they want to do something slightly different.

They want to go, you know, slightly down market.

The parent fund is going up market, or maybe they found a niche that they, an industry vertical, that they love and they want to go after.

Right.

And so

we have this advantage of the hunger of a new firm and the experience of having worked with somebody for

multiple funds at their prior firm.

So I think that's a good combination.

What we will not do is

three partners come together from different backgrounds

and start a firm de novo, like where we haven't had any

overlap with their prior firms.

So

that I think is

more challenging than one where we've gotten to know the principals who are starting the new business.

When somebody spins out, let's say I gave you 100 points, how would you allocate those 100 points to why they're spinning out economic reasons or non-economic reasons like culture and philosophy?

I would say 90% non-economic reasons.

They've become rich.

These are people who are general partners at very successful firms.

It has nothing to do, almost nothing to do with money, but it's always about they want their imprint.

They want

more control, and you know, it's it's usually not

pejorative about their relationship with the prior firm.

People just change directions over time.

So, so we spend a lot of time going into those personal motivations.

Like,

you know, where are you living?

Where are your kids?

What do you do in your spare time?

What do you, you know, like to do outside of work?

and the pattern is is always somebody that is completely motivated by the thrill of investing um

and they've reached a stage in life where that's the only thing that motivates them and to do it in the way they want to um

is is the the sole driver you mean versus

monetary reasons or versus other distractions or versus what versus uh you know, I want to build a new empire.

Like that,

and that happens, right?

So somebody comes and they want to recreate

KKR or, you know, they want to recreate Gollum.

And I find that's a bad fact pattern.

I love the person.

who wants to continue doing what they the skill that they've honed, the industry vertical that they've developed an expertise in,

with their own imprint, in their own way.

And presumably, you want them to stay small or you want them to stay niche?

I want them to stay at the size or grow at the rate that allows them to achieve their objective.

I know that a first-time fund in buyout space that raises $150, the next fund is going to be $500, the next fund is going to be a billion.

I know that because ultimately these people want to build capability.

Capability,

both in terms of resources, operating partners.

You know, they want to bring in people they've worked with at other firms.

And so

I'm not averse to people who want to grow their organizations.

I respect that, but it has to be consistent with their starting point.

Meaning, I love to do, you know, industrial companies in this,

you know, between

20 and 50 million of EBITDA.

And

I know that the market out there is there's 600 companies across these verticals that I want to pursue.

And I think that my market share can be this, and therefore I can be a billion and a half fund.

I think it has to be logical.

A good razor for this is GP commit.

Cliff Asness, we talked about this very topic, and he has LPs come to him and say, I want this type of fund, I want that type of fund.

And unless he really believes in it, which is putting a sizable GP commit, he's not going to do it.

He's not going to do something just because there's LP demand for it.

Typically, what you see with us, the kind of spin out we're describing, is the partner has made something like $25 to $100 million

at their prior firm, and it's all rolled into the GP commit.

Now, that might be

2% of a billion-dollar fund.

That's okay.

I think, but it's more the quantum of money in relation to

the person's total wealth.

And that's what matters to me.

It's not...

the size of the GP commit relative to the funds.

What goes wrong in spin outs?

What are some mistakes that you've recently made?

The most likely

is

bringing in partners that they've worked with tangentially, so not from their firm.

It might have been somebody who sat across the table on a different transaction.

It might have been somebody they know from their history who took a different path.

It's always a,

I'm going to assert, it's always a people issue, right?

It's not a, we

take too much risk and we're, you know, we swing for the fences and we get a zero.

It's

we came together and we didn't do enough work on what we wanted to be.

And what, and, you know, and therefore, you know, five years in or three years in, one of the partners leaves.

Say there's three GPs.

Why is it so destructive if one of the partners leaves?

It's not necessarily a fatal error,

but it's definitely not a good sign because it goes back to

how thoughtful you were at the outset about what you wanted to do as a group.

Now, sometimes somebody really just decides they have, first of all, they can have a personal issue.

Secondly, they just decide they want to do something different with their investing career.

Like, I just want to do angel investments, or, you know, I,

you know, want to spend time in a different area.

That's fine, but it does speak to the lack of cohesion at the outset and thoughtfulness about what the real objective was.

You manage $20 billion for clients, and presumably there's something that you'd like to do that's too risky for your clients that you don't do for your clients.

So I want to know what is the crazy Brad trade that you'd like to do, that you would do with your own money, that you wouldn't do with your clients' money.

So I manage a portfolio for my mom, who is 90 years old.

Okay.

And recently, meaning in the past two weeks, I took her to a 22-year duration in her fixed-income portfolio.

Now, she gives me, she's the best client I have.

She gives me a lot of leeway.

Luckily, she loves me,

apart from my investing acumen.

And that's something we could, we could never do that for a client.

However, we are tilting portfolios longer duration.

So this gets back to tracking error.

If we did the same thing for a client, then literally the entirety of their tracking error would be taken up with that one bet.

So let me go back to the case.

20-year treasury at 4.9%

is

an okay value if you think inflation is going to run at 2.5%.

That's a real rate of two and a half, right?

2.3.

That's an okay real rate.

It's probably

as high as it has been in 20 years.

What is different this time is that we are facing, I think, a big challenge in terms of growth in this country.

So the odds of recession have risen dramatically in the past two months.

And it's the combination of very attractive real yield, very high absolute rate, and very uncertain economic environment.

In other words, the insurance value of that 5%,

if the Fed decides we've got to cut rates,

if the Fed decides we've got to buy treasuries, that could easily be a four, it could be a three and a half within a few months.

And so,

at 20-year duration, you're talking about equity-like returns for a treasury on a real basis, 2.5% over treasury?

Yes.

Could you unpack that?

How's that equity-like returns?

If I buy a 5% bond and a 20-year treasury, and the rate, and let's say it's a 14-year duration, and the interest rate goes from

5% to 3.5%,

I make 22%.

Um, and so I think that is equity-like money.

Uh, in a very now, the problem is it doesn't, unlike equities, it doesn't compound, it's it's a one and done.

So, uh,

but at least in the short term, it's an equity-like return for a fixed-income yield.

What do you wish you knew before starting at Hurdle Callahan over 15 years ago?

I wish that I had

questioned more the

received wisdom.

So there are lots of standard operating practices in the asset allocation business, so managing money for asset owners that were sort of

received wisdom.

But when you tried to unpack it, it didn't have a lot of real fundamental justification.

When I joined here, we had a 20% allocation within equity, so 20% of equities allocation to small cap.

And I asked my senior colleague at the time, who is genius, by the way, I asked him, why do we have that?

And I expected from him, he's very academic, I expected a sort of a very well-thought sort of modern finance rationale.

And he said,

Because most other people, our competitors, have the same allocation.

And I wish that I had

been more skeptical of the received wisdom.

I've often thought about this.

It's a whole concept of why is common sense uncommon?

And

looked at it another way.

Peter Thiel would say it's so uncommon that Silicon Valley is filled with autistic people because you need almost a neurological disorder in order to be a truly independent thinker.

As everything, it has its

history in evolutionary psychology and evolutionary biology.

There was a huge survival advantage for humans that basically stuck together.

If you apply that to finance, it's basically indexing.

There's a huge survival advantage.

There's a concept called emotional

contagion, where emotions and memes and feelings are reciprocated within tribes in order to account for cohesion.

So another way a lot of people are just mimetic creatures, and there's a huge evolutionary incentive to stick to what everyone is doing.

Now, it's important to note the evolutionary context for that was millions of years ago when we were herd creatures and

on the savanna.

And you're not going to be eaten by a lion because you decided to underweight

the US and overweight Europe.

Absolutely true.

That

we're wired to feel comfortable in crowds

and people who challenge orthodoxy are usually

ostracized.

You could even take it a step further, which is today, 2025, the financial incentives are not to stick your head out too much.

If you're 10% over the index, that's much less beneficial than being 10% under the index.

It's costly.

So there's actually

this principal agent problem that we've talked about, and that's prevalent in finance.

Well, Brad, we have to do this again sometime.

This has been a masterclass.

I really appreciate you jumping on the podcast and look forward to sitting down soon.

Thanks for listening to my conversation.

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