E205: How to Invest like a Billionaire w/Founder of IEQ Capital

Tell me about where IEQ Capital is today.

Well, IEQ Capital Today is a registered investment advisor with 260 individuals, eight offices across the U.S., with just under $42 billion of regulatory assets under management.

And last time we chatted, we had this interesting conversation about high-risk tolerances and low risk tolerances.

And you said that both of those could be liabilities.

Double-click on why.

it's bad to have a high or a low risk tolerance.

Well, having a high risk tolerance means you might throw away some of the simple concepts of investing.

If you put all your eggs into one basket and things don't work out, you could lose the totality of your capital.

That would be an extremely high risk and that would be foolish.

But conversely, people who sit far too conservatively fail to miss out greatly on the opportunities to invest.

The easiest way to think of that is inflation raises your cost of spending over time.

If you simply sit in non

assets that don't create a rate of return, your real purchasing power, your ability to spend diminishes over time because the cost of eggs and butter and bread goes up every year.

So you don't want to have too much risk and you don't want to have too little.

You want to find the right balance.

And one of these interesting things about risk tolerances is that a lot of investors don't actually know their true risk tolerance.

Typically, they say they could take more risk.

Tell me about how investors could go about identifying their true risk tolerance.

Ultimately, David, unfortunately, experience is the greatest teacher, as evidenced by all the scars on my back from 36 years of investing in the investment management industry.

But I think the most practical thing to do is take a candid survey of yourself.

You have to look at your spending needs.

You have to make sure you put enough cash aside for rainy days and emergencies.

Common wisdom means that's anywhere from three months to one year's worth of spending needs up front to ensure if anything goes bad, you have time to weather a personal storm or challenge before you need to access your capital and then you need to think through what have i experienced in my in my life if at all when things haven't gone my way do i have the patience and self-confidence or at least the confidence in what i've put my money into that it will recover over time so the greatest uh protector is to diversify by spreading your assets across a variety of different things.

Any one event might hurt some of your holdings, but possibly not all of your holdings.

But this is learned through time and patience and experience.

There's no magic formula.

All that we know is when you do put all of your money into one thing, you're both creating a greater opportunity for wonderful fortune, but also calamity.

And the more you spread it out, the less likely you'll have a significant up or down move, but you buy yourself greater latitude to weather any short-term challenges.

The way that I kind of look at it is observing my own behavior, almost like I've gone outside of my body and observing myself.

And I look at a certain situation and

I sold too early or I didn't sell soon enough.

And then I asked myself, why?

What kept me from that?

And that's kind of how you build the self-awareness.

And you essentially start mapping out your own true risk tolerance by actual behavior versus perceived behavior.

So how you actually act in certain circumstances versus how you think you would act.

I'd agree with that.

It turns out psychologists have actually measured the pain of joy and the pain of loss.

And theoretically, the grief for or pain from losing money is more than twice as significant as the joy from winning.

And so often what happens is individuals have an investment that doesn't go their way.

And just like putting your finger into a flame, once you've done it once, you're less prone to do it a second time.

So whether it's having too much in one stock or too much in a cryptocurrency or too much in a venture capital fund or a private company investment, there's any number of ways that can happen.

But by learning what it means to lose money, hopefully becomes a teacher to be a better steward of your own personal risk tolerance or at least understanding how to moderate how much money goes into any of those risky singular investments.

So no one thing can unilaterally create terrible financial harm for you.

I want to double click on something that you said that I think people will undervalue in that you want to have that three month to 12 month runway.

Another way that I would reframe that is actually having enough of a runway or having a safety to your portfolio can actually allow you to increase your risk tolerance.

And a lot of the reasons why people don't have higher risk tolerance is they try to make every asset play every position.

But by having your fixed income, let's say, or treasuries be your safety net, you could actually take more risk than the rest of your portfolio.

I strongly agree.

Assuming, again, you're very clear about what you're using your investment portfolio for.

Do you need to draw upon it for income?

And if you you do, is it a modest amount to supplement your living expenses?

Or is it truly assets for long-term savings?

It's even easier to think of in some respects.

If I know I have an IRA or retirement account and I have no intention of touching it for potentially decades, I should have a tremendously high degree of risk tolerance because I have such a long-term time horizon.

What you're alluding to clearly is when you're talking about your own personal savings in your individual account, or maybe there's a family trust, and you have to balance out you and your spouse's or partners'

spending habits as well as your own likelihood of continuing to earn after tax a certain amount of money that can maintain your standard of living.

Having that extra cushion of balance of three months up to 12 months of cash knows that if there's some short-term event, it could be a medical event, it could be a change in lifestyle, it could be an immediate need to move.

It could be the need for a new car, a variety of things create these one-time unforeseeable cash drains.

And the question is, do you have enough cash saved to weather those unpredictable events and yet still sustain a real investment long-term plan?

And what you're alluding to, which makes sense, is as long as I have enough cash, I know I have enough cash to afford those unforeseeable events, medical events, changing, buying a new car, moving to a different house.

It allows me to have a longer timeframe for the balance of those assets and then allows me to take a riskier perspective because, as you and I both know, the more that I'm willing to tie up my money in a longer-term investment, history teaches us the greater the likelihood that there's a positive outcome, even if there's a short-term drop in the markets or other financial prices.

So, this might be a weird question asking somebody that's running an RA with $41.7 billion.

But is there ever a case where you wouldn't want a client to be fully diversified or leaning into specific asset classes?

And if so, why?

We work with individuals and entities of all different levels.

So

the recommendations that we must give as a fiduciary have to be beholden to their income needs, risk tolerance, time horizon, age, and

the entirety of their life circumstances or that specific entity's needs.

There could be occasions where an entity, as an example, is a small percentage of a much larger portion of someone's capital.

An example might be someone has a very small IRA IRA account in the context of a much larger estate.

In that instance, if they are truly prone to risk, they may conclude, as an example, investing in private credit, which is not taxed within a retirement account and currently yields something in the order of 10%.

They might feel inclined it's better to invest all of their capital in the retirement account in one or two private credit funds because it's just a piece of a much larger puzzle.

And yet, from a tax efficiency perspective, investing in a private credit vehicle in their IRA is avoiding current taxation on their income.

And they view that as just part of the aggregate allocation and therefore they might not invest any private capital in the totality of their taxable holdings.

There are a number of other examples we could work through, but it comes down to each individual's totality of their holdings and how they view each component.

that leads to potentially taking on greater degrees of risk.

But they need to understand when you're taking that concentration, there is an element of greater concern that

may not work out.

And you mentioned private credit.

You guys have quite a bit of private credit in your individual accounts for your end clients, which a lot of them are taxable.

What's the strategy behind that?

I know a lot of individuals don't like to invest in private credit for the

tax aspect of it.

Start from a concept that we believe that there's something called an illiquidity premium to be gained by an investor.

The idea is if you buy something that can be bought and sold on any daily basis, which is a stock, a bond, an exchange traded fund, a mutual fund, you get a certain rate of return.

To the degree you're willing to invest in what's called a private credit vehicle or any vehicle that doesn't trade on a daily basis, we believe as a result of that condition, you should be earning something higher, all things equal than an equivalent credit that can be accessed or sold on a daily basis.

That term is called an illiquidity premium.

There are a large number of academic studies that talk to there is this premium both for income-generating assets, which we often call private credit, and also for growth-oriented illiquid investments that have a variety of names, often known as private equity.

And so, we believe private credit is an attractive asset class if it's invested with a manager who is investing in literally dozens and, frankly, more likely hundreds of underlying loans so that no one single loan to one underlying borrowing company is likely to materially hurt your returns.

Used to be tied to something called LIBOR, it's now called SOFAR, the structured overnight finance rate.

Market conditions vary over time, but oftentimes a senior floating rate loan to a company that's private and is borrowing money, The rate of return that you, the investor, might earn on that single loan might be something of the order of that structured overnight finance rate sofer, plus anywhere from five and a half to seven and a half percent.

So we can talk about in a moment why we'd prefer it sits in some kind of non-taxable entity like an IRA or other retirement account.

And yet when I am a lender, in the event there's a problem with a company, I as the borrower, the lender, have the first claim on the company's cash flows or assets prior to any stockholder.

So I'm in a senior credit position.

Now, what I want to do is I want to go into a fund or with a manager that runs a fund who hopefully has hundreds of loans, and even better to the degree they can be loans made to private companies that are positively cash flowing, positive EBITDA, it's called,

and even better to the degree those companies are often owned by a private equity firm that has on its own validated and underwritten the financials that underlie the private company.

I end up in a position where I am lending money to upwards of several hundred companies in one basket.

And if any one or two or three companies default, first of all, that won't unilaterally take down the totality of the investment materially.

Secondly, because I'm the senior lender, I have the first call on capital when there is a workout.

And thirdly, the historical rates of return on these assets, even including incidences of defaults and losses, tends to be still in the high, upper single, high single digits or even low double digit returns, net of all defaults and losses.

So it's historically been an attractive risk-adjusted rate of return asset class, and it is best suited in non-taxable accounts, charitable remainder trusts, family foundations, donor advised funds, 401ks, retirement accounts, IRAs, Roth IRAs, so inherited IRA accounts.

So what we do at our firm is in the context of providing advice, to the degree clients want to access income generating assets as part of a diversified portfolio.

what we do is we focus on those accounts that aren't subject to ordinary income taxation and say private credit is among one of many illiquid strategies that we might utilize to help you build a well-rounded, well-diversified portfolio.

What we don't want to do is put all of that private credit into one loan to one company.

That's too much concentration in one thing.

So again, we're diversifying by the asset class itself, and then within the asset class, diversifying across one or more funds, each fund of which is spreading out the loans across dozens or hundreds of underlying companies.

So for these very reasons, there's a lot of people investing in private credit, and there's a concern that it might get overheated, just like any asset.

What would be the leading indicators that there might be too much money in private credit chasing too few opportunities?

Well, I don't know if it's too much credit.

chasing too many opportunities given the size of the market.

I think the greater increment is what happens is all things equal, the challenges in these companies is they are borrowing money and it's dependent on their ability to generate earnings before interest and taxes to pay you back.

So they are subject to the whims of a softening economy.

So the signals are less about how much money is flowing in relative to how the size of the market.

The size of the market is enormous.

The challenge is if you truly believe you are entering into a softening economy or really a recession, the likelihood is the revenues and therefore the earnings before interest and taxes that these companies are generating is going to diminish.

And the likelihood that some of the underlying companies will default on their debt payments will go up.

It turns out this asset class, even weathering through previous recessionary periods, has still performed reasonably well.

And typically, the actual losses incurred and the recoveries ultimately be a much better outcomes than what gets penciled out.

But it is, in fact, where the asset class itself gets challenged because most managers must do something called mark-to-market accounting.

So if you're a manager and you own a private loan, even if you believe the company will make its payments to its maturity, and in fact, even if the company is performing well, accountants will require that they mark each quarter, typically, the value of the loan if they were to sell it.

Even if they were to have no intention of selling the loan, if publicly traded, high-yield bonds are falling in value, privately held loans will be forced to mark to market their valuations lower.

So it will signify, at least on a client's account statement, that the value of the loan that was extended to the private company has fallen in value.

What you want to make sure is you are in a pool of loans with a manager who has the discipline to understand fundamentally what's transpiring with the company and whether it fundamentally can make payments on its loans through a recessionary cycle to the end point

rather than panic and sell at the wrong time and be forced to sell the loan when it's being marked to market down because of what's happening away from the portfolio in the broader, high-yield, publicly traded block.

Presumably, there would also be a secondary opportunity there where the asset is marked down, but there's still an ability to pay out the loan.

There would be, and in fact, that's another terrific asset class.

So, it turns out, amongst the many asset classes that we do direct some of our client capital to, it's an illiquid investment, meaning it doesn't trade daily, is the history of being a secondary investor, buying an illiquid position from the initial primary investor, oftentimes at a discount to its real inherent value.

It's a terrific strategy.

And

we do that on behalf of clients in a variety of asset classes, one of which is credit.

So we will use a manager who has expertise looking for limited partners, owners, primary owners of these credit funds who for various reasons need money today and are willing to sell their illiquid private loans to private companies at a discount to their inherent value.

And when that sale is being made at what we perceive to be a materially lower price than its true inherent value, its net asset value.

To that vein, there's famous investors like Warren Buffett that hoard cash for these

dislocations in the market where they go in and buy assets cheap or do convertible equity.

Do you have allowance in your strategy for being opportunistic during market downturns?

And how does one actually operationalize that strategy as an investment strategy?

It comes down to having your own investment policy statement personally to begin with.

And you have to decide whether it's prudent to persistently hold some amount of cash for opportunistic investing.

It is challenging.

And the reason it's challenging is it's difficult to time markets.

And if you think an opportunistic investment is going to come quickly to you, the problem is it could take much longer than you think.

And sitting in cash, whereas it might have been invested elsewhere is hard to do.

So what we aim to do with clients is make sure we have in alignment a strategic asset allocation.

They can conclude whether they want to hold some cash for potential opportunistic moments in time.

What oftentimes is done is looking at an asset allocation and making marginal decisions.

Rather than sitting with cash, which could persist for years, we think it's better to be pretty fully invested, but always be looking on the margin if one relative strategy pencils out better than the other, and if the transactional and tax-related costs to make the changes are warranted, then it's worthwhile pursuing.

If you can't make the tax-related and transactional related costs worthwhile, you might forego those opportunities.

It is incredibly hard to be an opportunistic investor because it's exactly the time things look so horrible that you're afraid to invest is exactly the times you might jump in.

If you look at just as an example, what happened to stocks this year, we had an incredibly rapid decline in the prices of global stocks and an incredibly rapid rally.

Had you not been dollar cost averaging into the drop or brilliant in your ability to pick the bottom in early April, you might have been sitting in cash and thought it was going to get worse and never put the money to work like you thought.

And here you would have been at the end of July, early August, and you still haven't gotten your cash put to work.

And so, we actually think you're better to define what your real long-term strategic target asset allocation is, get to that allocation, and then make marginal decisions as opportunities arise to determine, is there on the margin at that moment a better use of the capital?

And again, that strategic allocation can include cash for rainy days, emergencies, or opportunistic investing if that is your purview.

and you're willing to theoretically lose some of the upside to know that you can gainfully jump when an opportunity arises.

And just to use some back-of-the-envelope math, if your opportunity cost of capital is 8%

and you don't have a trade for eight, nine years, you're going to have to get at least a 50% discount when that market dislocation happens, assuming that you have the boldness to go in with that bet.

So I've always wondered how people time that market, but reallocating resources and reallocating asset allocation, maybe you take some off of public and you find that publics and privates are down on net.

They should be at about the same levels.

You see that arbitrage.

That makes more sense.

That's right.

I think it's very hard, especially when you, if you're going to use stocks as your benchmark, Albert Einstein, I think, said the eighth wonder of the world was compounding.

And so,

you know, I don't, it's a little known statistic, but apparently Warren Buffett made 99% of his wealth after age 65.

And it's due to the power of compounding.

He built a savings to a certain level.

And if you've ever heard of something called the rule of 72, it roughly means if

your money goes up 10% a year, it doubles every 7.2 years.

And so the power of compounding is very significant.

And if you miss out by sitting in cash, earning maybe 4% a year pre-tax, you're going to have a really hard time 2.5% after tax compounding and catching up with the power of stocks.

And that's why opportunistic investing is fraught with a lot of risk.

And someone needs to really understand, getting back to one of your questions about not having enough risk on,

by missing out on assets that typically grow over time an unwillingness to take on risk there's the unrecognized risk that you're not keeping up with inflation and you're not building enough savings for one day when you choose to retire and rely on your portfolio to support your standard of living later in life what's the saying i've predicted five of the last two recessions

or or you know what you know and you know what you don't know it's you it's what you don't know that you don't know that will hurt you

And to that vein, I want to be clear, I'm not calling you old in any regards, but you have had a very long and illustrious career.

And I often think about this concept of the compounding of relationships, the same like compounding of money.

Have you found like in the last five, 10 years, your relationships have really compounded or has it been more linear?

My relationships have compounded.

I think what happens is your circles and networks expand.

By the way, thanks for illustrious.

That's a That's a great term.

I think if you put on glasses and you start getting your hair gray, you get a lot of accolades in these businesses too.

But I wouldn't lose sight of the importance of a one-on-one relationship.

I mean, at the end of the day,

I'm blessed to have a large number of acquaintances.

You can only truly have so many friends no matter what.

But the value of sitting on this side of the interview with you.

Being in the business of service, of servicing that client is everything.

If you don't really have empathy, if you really don't care about the underlying client,

you shouldn't be in wealth management.

So this business starts with clients and doing the right thing for clients.

And it's incredibly gratifying to feel that

we enable clients to feel more comfortable with their wealth, to try and accomplish their own personal goals from a...

lifestyle perspective, even a philanthropic perspective, or a transfer of wealth to the next generation.

So really trying to get to understand people, really understand what are their primary objectives, what is it they're trying to avoid, and also try to coach them in a way to be prudent with their capital,

thoughtfully take calculated risks in a prudent way.

It's a really powerful dynamic and it's really gratifying.

That's why dinosaurs like me stay in this business.

I found, especially in the ultra-high net worth, there's a lot of skepticism.

So sometimes you need time in the ground.

You need to build credibility over many decades.

They say reputations are built over decades, lost overnight.

Certain things and certain relationships can only be built over decades, cannot be built over months.

It still takes certain types of relationships time to season.

Yeah, I think that's right.

And we're a service business, like many other service businesses.

We're only good as our last client.

We're only as good as our reputation.

And we're only as good as giving thoughtful advice that can last for decades, not just quick fixes.

41.7 billion AUM, a couple hundred clients.

You could kind of do the math.

And a lot of these people are the ultra-high net worth.

In what way do those portfolios differ for you from endowment style, say a Harvard, DL, name your endowment strategy?

Well, it's funny because we do like to fashion portfolios that do take advantage of this illiquidity premium like an endowment.

But the singular difference is individual families, at least most of their entities, are taxable.

So the number one thing we have to do is take into account the fact that taxes, all the investments being made are subject to taxation, which eliminates or makes far less attractive many investments, particularly when they're in high-tax states.

Secondarily, a lot of individuals spend a lot of money.

So it turns out not only are you getting taxed, but it turns out we have to account for people's cash needs and cash flows.

Thirdly, many of the individuals we work with have a wide variety of

investment interests that span into private markets, whereas they're investing in private companies that have repeated rounds of fundraising, or they might invest in variety of illiquid investments where capital is drawn in a venture capital fund or a private equity fund over two, three, or four years.

So we need to do some artful

cash flow estimations for these individuals as well.

Lastly, and importantly, many individuals recognize the importance of prudent estate planning.

This means anything from proper amounts of life insurance or disability insurance, the far more complicated issues that are aiming to transfer the wealth to their next generation, but in a way that might not steal the ambition of the kids, as well as tying in whatever philanthropic interests that they may have.

And so all of those elements affect how you think about investing.

You have to be prudent about how you're investing, timing the cash flows, making sure whatever strategies are put into place have the liquidity to meet

capital calls and other lifestyle spending needs.

So that impacts how we think about allocating assets for taxable families that are individual clients of ours.

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The thing I've always wondered about is what happens when a family office can't meet a capital commitment, has to borrow.

What are some tools available for the ultra-high net worth when it comes to short-term needs for things like private equity calls or venture capital calls?

That's a complicated question because it'll be case-dependent.

It's funny, oftentimes they don't have a, they don't have, they're not calling the rich uncle because they are the rich uncle, so to speak.

Solutions include, but are not limited to the following.

First of all, there actually are some organizations that will give consideration to looking at a basket of illiquid investments and might make a loan against that basket of illiquid assets.

Typically, that loan is at a much higher rate of interest than what you would imagine.

But for example, if you were to borrow against stocks, bonds, and mutual funds, you might borrow at a rate like so far plus 1%,

which in today's world might be 5.5%.

Loans against private assets could easily be double that amount or more.

So that's one consideration.

Secondly, this is where we talked about earlier, secondary investing.

It may be they're not going to be able to meet the capital call and they may have no recourse but to actually sell the underlying private equity fund to a secondary buyer.

It's exactly the kind of opportunity that we try to find on behalf of our clients.

A third possibility, and it's not clear, is they may have within their estate planning documents structures such that some other entity has the capability to loan capital back to them for a variety of reasons, which liberally interpreted or if literally interpreted, depending on the documents, might enable them to borrow against assets in another entity in order to actually meet the capital call.

So there are a variety of mechanisms involved, but it really comes down to the individual's risk tolerance and time horizon to conclude what's the most prudent course of action.

I want to double click on the stock loans.

If you listen to Elon Musk, you'd believe that every wealthy person is basically highly levered on these single stock loans.

How common are those and what are some best practices around those?

First of all, I don't believe that to be true.

That most people are leveraging or leveraging against single stocks.

I think that's a significant minority of the population.

I just want to put that out there.

I also think, secondly, when you're borrowing against an individual asset, whether it's a stock, let alone some other asset, you're putting yourself at pretty significant risk in the event the stock or the other asset falls.

I think we all know what a margin call is.

A margin call is when you might borrow against the value of a stock.

Say you borrow $50 against $100 worth of stock.

Typically, when the lending organization sees that the value of the loan is now 70% of the value of the stock, let's say the stock fell to $75 per share from $100 per share.

You were borrowing $50.

If you're borrowing $50 and the stock is now only worth $75,

the lender is going to begin to get anxious.

There's not enough value in the stock to protect the loan.

And if the stock continues to fall, the lender has the ability to do what's called a margin call.

They call the borrower and say, either you need to put up enough money to get back to $100, or we're going to immediately forcibly sell the stock at this low price, $75 or lower, and hand you back what's left after we collect our $50 plus interest.

You don't want to be in a margin call.

You don't want to have your loan or stock, underlying asset, forcibly sold at the worst possible time because you don't have the ability to come up with money to protect the loan.

So I don't agree with that assertion.

There is an argument, to be fair, to Elon Musk or whoever else has this point of view, that leverage on occasion can indeed be prudent.

If you believe your borrowing cost is significantly lower than what you can earn by putting your money into another asset, and in the event you're not putting yourself in undue harm and putting your point at risk of eventually being put into a margin cost situation, you might decide that it's worth what's called arbitrage.

The arbitrage is the rate of return you expect to earn, which will be higher than your borrowing costs.

It's also prudent on occasion to borrow because you could be in a situation where you have a short-term, somewhat arbitrary cash flow need.

So, as one of many examples, imagine you had a million dollars in a stock portfolio and its cost basis literally was $300,000.

You might be in between jobs and you have a three-month hiatus where you're not getting paid income, but you know you have the other job ready to go, but you need to pay your bills.

And let's say you don't have any cash in your bank account.

You'd borrow against the value of your million-dollar stocks for three months than to sell some of the stocks and pay a large capital gain tax just for the sake of raising cash, especially if you knew you had the other job lined up and ready to go.

So I can give you examples where borrowing money, particularly if you have discrete short-term timeframes, you can identify the next source of income to offset the borrowing, it's prudent.

But to think that someone should just recklessly, I don't know if recklessly is the right word, but aggressively borrow against assets to amplify their wealth, that's a lot of risk.

And that's something typically we would not be terribly comfortable with.

So tell me about your philosophy when it comes to picking GPs.

What's the right vintage or right size of a GP?

And how do you ascertain that within an asset class?

So picking GPs is somewhat art as much as science.

So what we aim to do is we look for an asset class we find to be attractive for a number of reasons.

We obviously interview a large number of GPs in the space.

What we look for in GPs is a variety of factors, including but not limited to the fact that typically there's a team approach.

So there isn't just one star, not a reliance on one key man or key woman.

Secondly, we want to see that whatever strategy they are deploying is consistent with what they have done historically, because that gives us confidence that they have a lot of pattern recognition and know exactly what to do.

Thirdly, what we want to do is we want to examine their prior funds and see if they've had anything called style drift.

So an example of style drift would be, you told me you invest in private companies in the technology industry.

And if I look at your prior company, you invested in technology, in companies that were in the healthcare industry.

That's style drift.

When a manager, a GP comes to us and says, we are going to be a technology private company investor.

If I see in the previous funds, they in fact didn't do that.

They drifted away from the style they said they were going to follow.

That is a significant negative R factor because we therefore would not have assurance that they would follow the mandate they're proposing to do in a new fund.

So if I get to the point where there's a strong reputation of the manager, there is not a single key woman or key man risk.

They have not demonstrated any style drift.

We then look at how much capital they're raising in this specific fundraise relative to the sizes of the funds they have raised in the past.

If we find that they're doubling the size of the fund in the new fund, and if they haven't hired any number of material senior people to manage the portfolio, it raises a question as to why are they raising twice as much money as they did last time.

unless they have enough individuals to support raising that amount of money.

So we look at the relative consistency in the fundraise or the degree which the fundraises are increasing.

If there's too much money being raised in the subsequent round for the same opportunity, and if they haven't materially staffed up the underlying team to support that amount of capital, we put to question why that's all happening.

Once we get past all of that, we then can assess whether that team has in fact invested prudently in the strategy they're going to.

The amount of dollars they're investing is appropriately sized relative to the total addressable market.

And then we can look at things like track record to determine whether or not we think they're a good manager.

But notice, I didn't go to track record first.

All those other boxes are, in our mind, more important because, in some respects, the track record is the byproduct of having the right team with the right amount of money focused on the right opportunity set at the right time.

All of those elements jump into how we think about finding the right general partner.

Said another way: the track record is historical.

It's lagging.

It's good if it's great.

But what you're saying is the leading indicators.

How will the franchise perform in the future?

Things like team, style drifts, fund size are

leading indicators, and the track record just is a lagging indicator.

Track records are important, but they can be misleading.

So when we look at track records, we begin to break down the previous funds.

And how are the returns earned?

So I'll give you examples.

Whereas in venture capital or even growth equity, you might find one or two companies in a portfolio drove the entirety of the turn, which would be reasonable.

You'd want that less to be the case, for example, in a private credit fund, where you'd want to see much greater consistency of performance across all the loans.

So what you're doing with the track record is you're teasing out

where the returns came from.

You try to determine if it's possible which individuals you can attribute each

piece of the returns they came from.

You also want to look at the vintage.

And you would want to look at the vintage, the year in which the fund was created, relative to comparable funds in the same year.

It turns out the vintage, or a year in which you choose to invest for many asset classes, is as or more determinant of the returns than the actual team you gave the money with.

That's particularly pronounced in more aggressive strategies such as private equity, venture capital, and growth equity.

It's a bit less pronounced in things like private credit.

But we try to look backward on track record, both absolutely, getting down into the details, and then prospectively and comparatively back out to the broader universe.

A lot of these diligence items you're stating as fact patterns, but even these facts are not 100% known.

Sometimes they need to be corroborated with references.

That's kind of the thing that glues together the mosaic of information.

Style drift, all these things could only be known if somebody was an investor at that time or working with them at that time.

You could always paint a narrative that shows that that's kind of what you were always thinking.

That's right.

So an important component of any investigation of a fund is talking to a handful of investors who are in the fund.

And what's best is not just the two or three that the fund or GP tells us, but to do our own independent research and find other LPs or investors in the fund.

that they didn't tell us about.

So one thing you can do is you go to the underlying manager and you ask for three references and you go to those three references and then you go back to underlying LP or GP and you say that those were great.

We want three more references.

Try and dig down another layer.

Another thing you should know that's also helpful is when we are talking to other institutional investors, it's terrific to have a conversation not just about the fund itself, but other funds and strategies they are

pursuing.

So oftentimes some of our deal flow or the way in which we source opportunities is by talking to likewise sophisticated institutional investors and identifying both asset classes or themes as well as specific managers whom they are investigating.

It leads us down other investigative paths that might lead us to other investment opportunities for our clients.

We discuss these facts on the ground, track record, style, team,

returns, vintages.

There's also an art to it, which is, I'm going to use avert vibes, but more relationship with the GP and how you get along with the GP.

Why is that important?

It's very important to have a relationship with a GP that's trusted and transparent.

There's a fine line between having complete access to information in a way that we can objectively evaluate it as completely and wholly as possible, relative to having what's called the endowment effect.

where I sourced an investment, I'm beholden to that investment, I've developed a friendship with that GP, and suddenly I'm biased positively towards that fund.

And therefore, I'm giving them greater forgiveness for things they might be done that I wouldn't like.

Either the returns aren't as attractive as I thought they might be, or they might change certain terms relating to the limited partners or clients that would be less friendly to the LPs.

So whereas it is critically important to have a strong, trusted relationship that's transparent with a GP, it's a fine line between that and a friendship to the point where it can befuddle or

muddle your ability to be objective.

Because ultimately, we're a fiduciary for our clients.

So we need to keep that in mind at all times and ensure that we continue to be a very mindful fiduciary.

You should know, as a matter of course, on roughly three-quarters of the illiquid investments in which we have invested, and I believe that numbers to roughly 200 vehicles over the last 10 to 15 years.

We have been on what's called a limited partner advisory committee, LPAC, roughly three quarters of the time.

We typically demand when we invest with a fund manager, we want to be on the LPAC.

The LPAC is sort of this convention that works for both parties.

The general partner likes to have the three or four or five largest and arguably most strategic investors well informed because that general partner is hopeful that those same three, four, or five large investors will reinvest when they come up up with a new fund.

So they're trying to make sure those limited partners are well informed.

Conversely, we, the limited partners, want to stay on this LPAC for two reasons.

One is we absolutely want to have as much transparent and up-to-date information as possible to ensure that we can keep our underlying clients informed.

And secondly, to the degree we can have an active voice and

to the degree we can articulate limited partner client-friendly policies, procedures better reporting better packages more frequent communication it's our mechanism to communicate that to the gp to create a better client experience so whereas we won't make investments the gp is making the investments we're trying to ensure that the information coming is consistent with our expectations trying to keep the gp beholden to the mandate what they claim they do so not style drift and most importantly be able to have smooth communication so we aim to be on the l pack R typically about three-quarters of the time.

And that's the mechanism to try and keep the GP relationship trusted, transparent, healthy, but still client-centric.

You seem to have mastered this, the art of keeping good relationships while having good governance.

What's the key to that?

And tell me how you manage those two somewhat conflicting drives to want to be the GP's best friend, but also make sure that they're doing a right and professional job.

Well,

general partners have to raise capital in order to run their funds.

So they're going to work hard to ensure that we are well served.

We at IQ Capital typically will invest $100 million or more of client capital into a vehicle.

And so we're deemed effectively to be an institutional investor.

And therefore, GPs recognize that we are an entity.

If they are able to get us to agree to invest in their vehicle, it's a lot easier than chasing 100 investors with a $1 million capital commitment each.

So they have a lot of interest in keeping us happy.

Conversely, and to be clear, we're in the business of working on behalf of our clients.

Just can't see it any other way.

If we don't have a client, we don't have a business.

Whereas we absolutely want to have healthy, strong, trusted relationships with the fund manager, the GP, we can't can't lose sight of we work as a privilege on behalf of the client.

And therefore, everything we do and must accrue to the benefit of the underlying client.

And we take it personally because as we talked about, your reputation is everything.

Let's talk about the 800-pound elephant in the room, the debt.

I know last time we chatted, we talked about it.

How does one account for this growing national debt practically in their portfolio?

So it's a macro economic issue, right?

It's not going to affect day to day what's going on in my personal savings and spending account.

But at a macro level, you've got a real conundrum is the U.S.

national debt just continues to grow.

It's not new news.

It's been around for decades.

It just keeps getting exacerbated.

The conundrum, just so we can describe it, is basically this.

David, imagine you came to me and you had $36 million in debt personally.

And you were spending $2 million a year more than you were earning.

And you said, hey, can I borrow any money from you?

I'm like, are you crazy?

You're 36 million in debt and you spend another 2 million in debt every year?

I wouldn't give you a penny.

Well, if you go to the US and it's got a $36 trillion debt, it's spending $2 trillion a year more than it's earning.

It can borrow money all day long, 10 years fixed at 4.4%.

It's the same thing, except the government has the ability, obviously, to raise taxes or generate other forms of revenue.

So at a high level, there's only five things that can be done when there's debt like that.

One is the U.S.

government can turn to other countries and say, will you lend us money?

Hey, Germany, will you bail us out like you bailed out Greece in 2011?

Well, no one's going to bail out the U.S.

because we're the biggest financial entity in the world.

So that's not going to happen.

Secondly, we can sell our assets.

We could sell the Washington Monument and Mount Rushmore and the Pentagon, but we're not going to do that.

Third thing we can do is we can balance our budget, but it's pretty evident we can't balance our budget.

I think Elon Musk just came in recently and tried to figure out how to do that.

And I think he walked away pretty disappointed.

It was pretty much impossible to do so.

So if you're not going to get another country to lend you money like that, if you're not going to be selling your assets, and if you can't balance your budget, you only have two things you can do.

You can inflate your way through the problem

or you default.

The way you inflate your way through dollars, you know, I owe you $36 trillion.

I'm just going to print more bills.

Here are more dollar bills.

I'm giving you the dollar bills.

They're just not worth as much in the future.

That's inflation.

So how does this all trickle into how do we solve today's problems?

Well, the answer is several fold.

First of all, it turns out the U.S.

is still by far the most stable economic and political system we have globally.

So until we find a better system, whether you think it's Bitcoin and other cryptocurrencies, whether you think it's the EU with the Euro, whether you think it's Japan with the yen, until there is a different global financial system to replace the U.S.

dollar, we are not likely to see a change.

Therefore, investors will continue to fly into the dollar and enable us to finance our debts, even if it's growing.

Secondly, and importantly to understand this, you can sustain your debt level as long as you're growing as a country faster than your cost of borrowing.

So if you actually look at America's average cost of borrowing across Treasury bills all the way through long-term debt, it's somewhere around 4%.

Turns out, if you look at our nominal GDP rate of growth as a country, that means our real GDP, real economic growth plus inflation, it's kind of running around 5%.

If we're growing at 5% and we only have to pay off our debts at 4%,

you can actually sustain this for quite a while.

This is why if you hear a lot of financial figureheads, they'll argue that when you see the 10-year treasury bond yield getting getting up above 5%, it begins to scare the financial markets.

It scares the financial markets for two reasons.

One is the cost of borrowing is going up and it's clearly a disincentive for corporations and individuals to borrow money, which means spending will drop and you're on the precipice of potentially slowing the economy into recession.

But secondly, it's a real problem because it signals that at some point the U.S.

government won't be able to tolerate its borrowing costs.

What's happened in the past is every time the tenure has approached those levels, risk assets tend to sell off.

It becomes a self-fulfilling prophecy.

What happens is

risk-off investors fly into the US dollar and the treasury bond and it pushes the yields down and we reset again.

But as long as we're continuing to grow as a country faster than our average borrowing cost, this dynamic can persist for quite some time.

But there's this reflexivity that I think a lot of people don't appreciate in all this in that if you you started paying down the debt, the 10-year would go down and the cost of capital will be lower.

And the same in reverse, when we see that we can't balance the budget or when Doge fails, some people become more skeptical and then the 10-year goes up.

So it's not just this linear relationship that people expect.

It's the U.S.

government itself is an actor in its own financing, for lack of a better term.

I think that's right.

The other way to think about it, too, have you heard the saying,

if you owe the bank a little bottom of money, the bank owns you, if you owe the bank a lot of money, you own the bank.

You have to realize that a lot of foreign countries, China, Japan, Europeans, own a lot of U.S.

debt.

It's not in their interest to have U.S.

debt default either.

And so they don't want to see rates move up meaningfully either.

It would throw a kilter the global economy, not just the U.S.

economy.

We're incredibly linked, tariffs or no tariffs.

And so we actually have global interest largely in alignment to find ways to operate financially, even with the U.S.

running at a high debt level.

So other countries that are holders, some people argue the risk is China and Japan will boycott our bonds.

It's actually not in their best economic interest to do so.

And so the likelihood of foreign flows meaningfully flying out of the U.S.

debt market is pretty low right here.

You mentioned crypto.

Is there a rational amount for high net worth people to have in their portfolio?

And how do you think about it?

Give me the framework in which to think about crypto in a portfolio.

Crypto, just like any other asset class, is a personal preference of an investor.

So it's no different than me saying to you, do you want to buy small cap stocks or do you want to buy real estate?

It can play a role for clients that believe crypto is a prudent piece of a well-diversified portfolio.

It's a harder asset class for some clients to take on because it's a relatively new asset class.

And so we find a lot of clients choose not to invest in it because it's just just beyond their level of comfort.

But for clients that feel that crypto is a viable asset class, no different than gold or real estate or large cap stocks, then you would allocate some portion of a total portfolio to crypto just as another means to hedge oneself.

If we think about what crypto is representing, we think about it typically in the terms of it's an electronic store of value akin to gold.

So if I were to tell you 10 years ago, here's a piece of gold, a coin, and I want $1,000 bills for that coin for each ounce.

Today I want $3,000 bills for that gold coin, which is an ounce.

The gold coin never changed.

It's the same gold coin 10 years ago.

It didn't really have much practical use.

What changed was the dollar fell in value and I want three times as many of those dollar bills for my gold coin.

If you believe in the thesis of cryptocurrencies, and I'll pick on Bitcoin, which in theory will have a limited issuance of Bitcoins between now and 100 years from now.

The Bitcoin, just like a gold coin, is an alpha, alphanumeric code.

And today I might want 118,000 of your dollar bills for my Bitcoin.

I don't know what I'm going to want in the future, but if you think the dollar is going to drop in value, then you believe that down the road, someone's going to want a lot more dollar bills for that same alphanumeric code.

But I think that concept is incredibly challenging for many people to get their head around and so again gets back to personal preferences as to whether or not crypto should be part of a well-diversified asset allocation it's just yet another another asset class well alan this has been great to chat on ria investing and everything how should people keep in contact with everything that you're working on how should people follow you

You can find all of us at IEQ Capital.

You can go to our website.

You're welcome to take a look and reach out to any of us, easily found.

You'll find that we're publishing some thought leadership on our website as well.

Some of us can be found on LinkedIn as well.

And we'd love to hear from anyone who would like to be working with a fiduciary who creates bespoke investment asset allocations for their unique investment needs.

Perfect.

Well, Alan, look forward to continuing this conversation in person.

Thank you for taking the time.

Thank you.

It was a pleasure, David.

I really appreciate it.

Thanks for listening to my conversation.

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