E150: Tax-Aware Investing: Insights for Family Offices and UHNW Individuals

Ultra-rich, the billionaires, the sent-up millionaires are using a very specific type of tax loss harvesting. I know we can't talk about the players, but talk to me about the strategy at a high level.
We talk about like industry innovation 1.0. That was, you know, years ago, probably maybe 12 to 15 years ago, investing philosophy called direct indexing came about.
If you think about what an index-based investment is, you buy the S&P 500 and ETF mutual fund, you're just passive. You just want to own the market and get the exposure to it.
No more, no less. But let's say you own the S&P 500 ETF and the market is flat at the end of the year.
If you looked under the hood, you've got stocks that shot up 20%, 50%. You have stocks that shot down.
But if you just own the ETF, you don't really have an opportunity.

So direct indexing, which has been a very quickly growing investment strategy is saying,

I don't want to take the active manager stock risk.

Picking Apple versus people, give me all of them.

Just like when I buy the ETF.

I do it in my own account.

That way, I can take advantage of tax loss 100%.

Individual security level. When you think about investing, how do taxes play into your strategy? There's a famous saying, it's not what you make, it's what you keep.
As someone who's helping taxable investors invest, we always have to be thinking about taxes and how to have the most tax efficient. And how do you quantify that? How much do taxes actually play an effect on your clients' returns? There's a lot of factors.
First, what state do they live in? If you're in New York, Hawaii, California, taxes become a much bigger issue. But, you know, still federal income taxes on ordinary income, you know, north of 37%, capital gains north of 20%, you know, once you factor in state and some other stuff, it absolutely reduces the net return to a client once you start factoring in taxes.
So how do you then build a portfolio that pays attention to taxes? Another saying people say is don't let the tax tail wag the dog. You still have to make sound investment decisions, but you should absolutely be aware of what those tax rates are.
I've seen a lot of very smart, very wealthy people make these almost emotional decisions, putting in their money into investments that they shouldn't have just to minimize taxes? The worst outcomes that we've seen over time, and you've heard these stories, you know, going back to the dot-com bubble, is people would take a company public, have huge amounts of net worth, but they don't want to pay the taxes. And then they sit there and watch it go down and down and down.
And I don't want to name specific examples. There's a lot of companies that had great stock prices at one point and went down by a lot.
So letting the tax tail wag the dog sometimes makes sense, but generally you really have to be thinking both investment return plus taxes when you're making decisions. Let's say that I start a startup.
I'm the founder and CEO. I own 20% of that company, goes public.
It's worth $2 billion. What's the right way to think about what to do in terms of your stake, in terms of tax strategy? Walk me through how a founder should think about their holding.
This is an interesting question because we deal with this a lot. We're financial advisors.
We are risk managers. To us, you may have the best company in the world, but 99% of your net worth is tied up in one company.
You should absolutely be diversifying. But we don't know nearly as much about that founder's company.
It's not just the tax thing. It's also this dynamic of someone wanting the exposure and risk to that company, where we are not wanting concentrated exposure to anything.
First, it's about having that conversation so that when I tell them, I think you should diversify, they know it's not because I think your stock is junk. It's because I think you should diversify because it's not worth that risk.
But you start talking about, let's say we just pay the taxes. Where are we? Right.
And is that a good decision? Then you start looking at things like exchange funds, tax loss harvesting. You can do options overlays to help reduce concentration risk.
So I would say it's like a two-part thing of making sure they understand where we're coming from and then helping them kind of get to that point of saying, okay, I get it. Now, how do we do that in the most tax efficient way possible? A lot of founders get overwhelmed by they're trying to run and trying to start this $10 billion company.
And now they have to deal with hundreds of different tax options. So they end up doing nothing, which is the worst thing.
Let me through kind of from an 80-20 perspective, where should founders focus their tax optimization? There's two important things that there's estate taxes and there's income taxes. Maybe I'll just touch on estate taxes for a second.
So we see a lot of people start to generate significant amounts of wealth in their estate beyond money that they would ever anticipate spending. And they know that, yet they don't engage on the estate planning process to move some of that wealth out of their estate for their kids and future generations.
First, we would always want people to be aware of where is that number? Where are you comfortable starting to move some of that future appreciation out of your estate? We've seen families be incredibly smart about this, where they're starting a new business, they're very confident it's going to work well, and they have this business be held outside of their estate. And things go extremely well.
When that business sale happens and all that wealth was created, it can be held outside of that person's estate. Estate taxes, I think you have to be thinking about when you're having a very high growth, hyperscaling type company.
The second would be income taxes. Now you want to sell the business, right? You want to liquidate it.
Well, if you could be QSBS eligible, that's one way to really save money on taxes when you're starting a business, you know, kind of do what you need to do to be within that. Two, if you go public and now you have public company stock, while you're restricted, you can't really do a lot, but let's say you're no longer restricted.
You're no longer at the company. One of the historical ways people would look at doing this is put it into an exchange fund, right? Where you and other people with highly concentrated and highly appreciated public company stock all put it together into a fund that the managers of these do a good job of making sure it resembles what the market looks like.
You're diversifying your risk with other people all going together. And the last thing which we've seen a really big increase in over the last couple of years is using tax loss harvesting to offset some of the gains you take when you diversify or reduce your exposure to that concentrated position.
But all those things come together and having a conversation, really understanding someone's objectives. But there's a lot of tools out there.
And if you're working with the right advisor, they're going to know about it. But if you're not working with advisors that know about these things, if you're not coordinating your CPAs, your state planning attorneys, and your financial advisors, you can miss out on a lot of opportunities.
There's a lot to unpack there. Let's start on the state tax aspect.
One of the issues with that, or one of, I guess, my frictions with that is if I was to put some of my company or some of my investments to my kids, they wouldn't necessarily manage the money as effectively as I could. So talk to me about the trade-off between gifting or giving away those estates and also the management of the funds.
Great question. You can have your cake and you can eat it too.
You can transfer wealth to future generations and still be in control of how that money is invested on their behalf. whether you use an LLC where you're the manager of it, or you or someone you trust is the trustee of those trusts, these dollars are typically not being given directly to these future beneficiaries.
It's being done in trust or LLC structures that allow the grantor or the, you know, the person who transfers this wealth to maintain control and investment capacity. Now they've given the money away, so they've parted with the economic value.
But as we said before, once you've gotten to a certain point of wealth, you may be very comfortable doing that and helping to avoid really large estate tax bills. I know a lot of the very wealthy worry about the psychology of trust and giving money to their kids.
You've seen this play out now over a couple of decades. What's the best practice there? This is a great question.
A lot of family offices have entire groups literally dedicated to future education planning. I would say for the most part, obviously you don't want your kid at 13 knowing the wealth that they're going to have.
But for the most part, the most effective families that we've seen with wealth transfer are transparent and open, educate their kids on what this wealth means, what it doesn't mean, and start from an early age to train them to be a steward of their family's capital. And the ages where we typically see families start to educate their kids is, call it like post-college, once they've started into the working world.
And I think part of that is you have this fear that my kid's not going to be motivated to go to college, get their first job or whatever it is that you might want for them. And then once they get to that point where they're now in the working world, I see that that's pretty common.
Now, depending on your wealth, your kids are going to know how wealthy you are, or at least have some directional idea. But we generally see families getting their kids more exposed to and educated about the family's wealth once they're kind of in the mid-20s.
It's interesting. It's more about behavioral conditioning than it is necessarily about people really focus on the money versus the behaviors of the kids.
And teaching your kids, for example, what it means not to have money. You give them an allowance and they really want to go to this arcade.
They spent their money on ice cream and now they have to feel the pain of not going to the arcade because they didn't budget. Having a behavioral conditioning from an early age, I think is important.
And just like good parenting, sometimes it hurts in the short term, but you're preparing your kid for the long term. I can't tell you how many wealthy clients I have that stress about this, right? I don't want to screw up my kids, right? And look, these are great parents because they're thinking about it already.
But you know, they just there's, you know, it's forget the from shirt sleeves to shirt sleeves, as they say, you know, the third generation. Luckily, I think the families that I work with, they're doing a great job of education and kind of really instilling great values into their children.
Yeah, it's definitely more emotional than just like money. It's more about values.
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The way that I think about is how do I get my kids, I don't have kids yet, but how do I get my future kids to change their motivation to why they work? And how do you help them find that passion so that work doesn't become an ends to pay their bills, but actually becomes something that brings them meaning and purpose in life? I wake up every day and sometimes I'm so busy, I can't breathe, but I love what I do. And I feel that way.
And I was just on a group chat with my family. And so there was an article, I think it was from the Wall Street Journal yesterday that said, tech entrepreneurs want their kids to go into the arts.
And I was like, I want my kids to be teachers or doctors. And I think everyone's got this different view, but you want to enjoy what you do.
You want to be fulfilled. You want to feel adequately compensated.
But I think that's one of the benefits of wealth is that it can allow people to live a lifestyle that they want while also living a fulfilling career. It doesn't have to be mutually exclusive though.
In an ideal world, well, first of all, teachers need to make more money. But in an ideal world, you'd be able to pick the profession you wanted and be able to live the life you wanted with that.
It subsidizes whatever delta so you could optimize on what you really want to do. Yeah.
Yeah, absolutely. Estate planning, which is basically giving, if I was to summarize that, it's putting assets at a low basis into a trust before they rise in values.
Correct. And whether it's a low basis or high basis, you typically would only put assets into these types of trusts if you thought they were going to appreciate in value.
Some families don't like to do it, but the federal estate tax is 40% after your exemption is used up, which means that all that growth over the next 10 years, 40% of it's going away. So over the next 20 years, whatever it is, 40% of that growth of whatever your dollar amount is today will go to the government.
And some people don't mind. Most people mind.
When you're past your exemption, you put that into trust that's essentially taxable. This is great.
We're getting into an estate planning discussion. Once you're past your exemption, those become taxable gifts.
And there are, you know, but there are ways to transfer appreciation outside.

You can make loans to those trusts. You can make, if you make a loan, you can charge, you have to charge interest, but let's say the applicable federal rate is the minimum interest you can charge.
Let's say it's four and a half percent right now, but you're like, no, my company is going to grow at 40 percent per year. All that appreciation exists outside of your estate.
Expert in QS. We talked about estate planning.
Now let's go into income tax planning. I've gone deep down into this rabbit hole of tax loss harvesting.
It seems to be a highly undervalued strategy. Tell me about tax loss harvesting.
The IRS taxes assets when you dispose of them. What that means is if I sell Apple stock that I bought in 1987 and I made great money, I only pay the tax when I sell and recognize that gain.
But if I let it just keep growing forever, they don't tax the unrealized appreciation. Now, last year prior to the election, there were some talks about at certain wealth levels where they start taxing unrealized appreciation.
Let's just move on from that. Right now, you buy an asset, it goes up in value, you don't sell, you don't pay taxes until you sell it.
And conversely, if you lose money on an investment, you don't get the tax benefit until you sell it. Tax loss harvesting is the approach of when I have assets that go down in value, I will sell them to recognize the loss, which helps me offset gains that I took elsewhere.
Perfect example, David, you know, your podcast company, you become the biggest in the world, right? And you sell this business and you have a realized capital gain because you have no basis in this, whatever you put in to start this business. And you're going to owe tax on that.
But let's say separately, you had bought a lot of, you know, I'm not going to pick on any companies, but a company stock that goes down by a lot, right? You have no tax benefit until you sell that. But if you sell that in the same year that you sold your company, you can offset that gain and loss against each other to reduce the tax liability.
Now, tax loss harvesting has been around for a long time. Financial advisors have always employed this philosophy of the old school way.
Let's get together in November, December of the year and sell your losers just to harvest some losses. What's funny about that is two things.
2020, COVID hits. Markets down 35% in a span of four or five weeks.
But if you just looked at calendar year returns, the market was up. If you waited till November, December, losses weren't there anymore.
You had the tax loss harvest in March, April time. The second thing is that that old school model where everyone was tax loss harvesting at the end of the year started to actually put pressure, further pressure on stocks that had done poorly that year because everyone was tax loss harvesting in November, December.
Everyone owned similar stocks and it would put further pressure on those names while you were harvesting your losses.

And I'll pause there in a second, but the world and technology and financial innovation have changed the way that tax loss harvesting is done and continues to innovate. That's tax loss harvesting 101.

The ultra rich, the billionaires, the centimillionaires are using a very specific type of tax loss harvesting.

I know we can't talk about the players, but talk to me about the strategy at a high level.

First, let me talk about like industry innovation 1.0. That was, you know, years ago, probably maybe 12 to 15 years ago, investing philosophy called direct indexing came about.
If you think about what an index based investment is, is you buy the S&P 500 and ETF mutual fund, you're just passive. You just want to own the market and get the exposure of the market.
No more, no less. But let's say you own the S&P 500 ETF and the market is flat at the end of the year.
If you looked under the hood, you've got stocks that shot up 20%, 50%. You have stocks that shot down.
But if you just own the ETF, you don't really have an opportunity to tax loss harvest. Indexing, which has been a very quickly growing investment strategy is saying, I don't want to take the active manager stock risk of picking Apple versus Google.
Give me all of them, just like when I buy the ETF, but do it in my own account. That way I can take advantage of tax loss harvesting at the individual security level.
These days you can do this with Vanguard, Fidelity, Schwab. Every financial advisor has access to this.
This isn't an access thing. This is just a knowledge thing of knowing it's available if you want to be an index-based investor.
To me, it's a phenomenal way to own the public equity markets. Innovation 2.0 has been the introduction of long short strategies where instead of just buying, you give someone a million dollars for a direct indexing account, they buy a million dollars long of stock.
Well, the market goes up over time and you've eventually harvested all your losses. So you don't really have many opportunities to loss harvest anymore.
But in a long short application where maybe you give them a million dollars and they buy two million of stocks and short one million of stocks, your net exposure is still only long, one million. It's still all you have in the market.
However, you've now have three million of gross positions, the two long plus the one short that they can tax loss harvest on. There's a lot more notional opportunity there.
The second benefit is that you got some shorts in there. And if the market goes up over time, you're going to consistently be able to harvest losses on the short side.
One caveat I'll make is that direct indexing truly is passive. It's I want to replicate the benchmark.
I want to own the benchmark. These long short strategies, though, you you are taking on an additional risk or opportunity.
Risk isn't always bad. In the form of manager stock selection, there is an active manager choosing which stocks to go long, which stocks to go short.
And that's a risk and an opportunity. Lately, for the manager we use, it's been great, right? But we have to know that we're taking that.
You talked about going 200 long and 100 short. There's also a popular 300 long, 200 short.
Yes, that is available. I would say the most common version is actually a lot more tame.
The most common version, and people might've heard of this term before, is 130-30. That's 130% long, 30% short, right? And then depending on which of these platforms and managers you're working with, they will allow you to scale up.
You can go to 300, 200. We have clients that do it, but you're taking on a lot more stock selection risk.
You're going to also, if it works out, get a lot more benefit, a lot more market outperformance, a lot more losses. I'm comfortable with it, but a client typically would only reserve something like that for a financially sophisticated client who understood what this tracking error meant because you're taking levered exposure to a manager stock selection risk and it can go fabulously well or it can hurt you.
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Some valid criticism of a lot of these tax strategies is they're at the margins, but this tax loss harvesting seems to be a huge effect. Let's bring it down to brass tax.
You invest a million dollars into the 200, the 2X long, the 1X short. What is the expected tax benefits on year one? Depends on the environment, the manager, but I'll put it this way.
In a strategy like that, you could probably get 40% of your NAV in losses in the first year. And your return will be the market return plus or minus the tracking error, the manager's skill.
But the loss, those numbers are very meaningful. Now you're just in the higher leverage strategies, the losses are even bigger.
But I like the numbers you use. I'd rather stay there.
And I'd call it 40% of NAV probably in the first year. And those will persist.
And what would you expect in year two, year three? It will go down, but not by a huge amount. Maybe you're at 35% the next year, then 32.
But over time, you kind of get to a place where... because remember, we're long and short.
And so we're always getting the opportunity to be harvesting when the market's down, we're harvesting losses on the long side. When the market's up, we're harvesting losses on the short side.
And so these strategies can benefit from a tax perspective consistently. It's very exciting.
And the managers are, these are very high quality institutional managers that are implementing strategies like this, which by the way, you want, you don't want to be with a small, in my opinion, you don't want to be with a small startup group that's applying leverage in your account. You'd rather be with a large institution with significant experience and track record and the ability to manage these types of strategies.
These are estimates, but first year you might get 40%, then you make it 35, then 32%. You're getting a $400,000 short slash long-term capital loss in year one.
Correct. And that $350,000.
Talk to me about the long-term strategy. When do you sell? Industry innovation is so great, David.
It's like, let's say you want a hedge fund, right? A market neutral hedge fund where you want to take someone's stock selection risk, but you don't want the market exposure. You can go into a market neutral hedge fund.
These separately managed accounts now allow an investor to make those decisions in their own accounts that gives them more control, more transparency, lower fees. It's like you could run these strategies at market neutral.
So you don't need to buy 2 million a stock and short 1 million a stock. You could buy 2 million a stock and short 2 million a stock.
It gives control to the investor to really customize their experience. And the level of transparency is so important too, because you're in a hedge fund, you're in a black box.
These strategies, the investors and their advisors know every position in that account on a daily basis. They have the ability to make changes.
And for the players out there doing this, please don't raise your fees, but they are expensive, but I would say very reasonable for the benefits and value we are getting. So now to answer your question.
On the 200, 200, so you're giving up the long, right? So on average, S&P might go up 7, 8, maybe 11% on a year. You're giving up that upside, but you're taking away some volatility and it's less risky.
Today is March 6th and the market's been down, you know, about five and a half, the US market's been down about five and a half percent over the last 10 days. Our market neutral accounts that we run, every account is different because remember it's customized.
Those clients have made money over the last week, right? Their accounts are up while the market's down. Because it's market neutral, it doesn't matter what direction the market's going in.
It only matters the stock selection risk of the manager you select. The manager has, they have to short half their book, they long half their book, but they get to choose the companies they've essentially demonstrated alpha exactly there's been alpha in the last week that 200 yeah that 200 to 200 portfolio what amount of capital losses is it generating on a yearly basis this one about that same 40 i told you about same 40%.
Yeah. A little more because the reason is 200 plus 200 is for, you know, it's a 400% gross for the 200 by 100 or the 2 million by 1 million is a 3 million gross.
Let's get back to the tax strategy around it. By year three, if I have my math right, you're going to, you invested a million, you get a million in capital losses over three years, probably more.
What does that do to the basis? And talk to me about how you use a strategy practically in a portfolio.

This is so important because this is not a short-term strategy.

You are trading one thing for another.

And what you're trading is realized losses today for very large unrealized gains sitting

in the portfolio.

This is not something someone can get in, get out.

You know, this is a planning strategy that you have to have a long term mindset of how am I going to manage this and own this portfolio for a very long time. If you walk away from that, let's say you want the losses.
I get them this year and next year. Great.
I'm done. You walk away.
You're just picking up the gain next year. All you did was one year tax, like, you know, a deferral.
That is not that valuable. Tax deferral for 20, 30, 40 years is incredibly valuable.
That's why people take advantage of 1031 exchange in the real estate market. It's, I want to continue to defer my gains on these investments for as long as possible.
It's not a get in, get out. It's a get in and manage accordingly over time.
These are liquid. I just had a client pull some money up today from one of his accounts.
They're liquid. You can manage this, but you have to be aware of the fact that there will be very large unrealized gains in here and manage around.
The deferral of it is essentially like you're investing the government's money on a compounding rate. Or let's say you put in a million dollars, let's say by year three, you get the million back.
Let's say you live in New York or California, 35 to 40% money. So it's as if you're investing the government's 300, 350, 400,000 at a six to 11% return compounding for many years.
Exactly. You just did the math and the calculation exactly.
And that's meaningful. And that's why you meet someone who's in the real estate industry and they say, I'm going to die with this real estate.
The 1031 trade for stocks. And then of course, if you're below the capital exclusion number, you could just gift that to your kids and that has a step up in basis.
So let me clarify. When you gift an asset, it has carryover basis.
So if I gift that asset to my kids during my lifetime, that's fine. It reduces the size of my estate, but they still have the same tax.
That tax thing doesn't go away. But if you pass away with that asset, it will be in your estate and subject to estate taxes, but you will get the benefit of a step up in basis.
When you pass away with something, the government looks at all your assets and tallies it all up. Here's what it is.
Here's whatever exclusion you have left. And here's your estate tax.
And then your kids will now inherit after the estate tax, they'll inherit those assets with a step up in basis. What if you gift that to a charity?

Point. We always tell clients, do not write a check to charity.
Give them your highly appreciated assets. Give as much as you want.
Give, give, give. But if you've got highly appreciated assets, let's say you put a dollar into Apple stock and it's worth $100,000 today.
You're sitting on a $999,000 potential capital gain if you sell it. You give that to charity, the IRS gives you the benefit of a $100,000 deduction, but no one has to pay that unrealized capital gain.
You get the benefit of the value of the full amount, but you don't have to pick up the cap gain that's sitting within that Apple stock.

We are big proponents of donating highly appreciated. So in this case, if you held it for 20 years, it went from 1 million to 3 million.
After having all those losses for 20 years, in year 20, you could now gift that for 3 million, get another 3 million capital loss. You get a deduction.
Capital deduction. Wow.
of deduction, which is the amount you can use each year against your ordinary income is limited to

either 30 or 50% of adjusted gross income. But this is a very meaningful and powerful thing for charitable families is to give appreciated assets.
And the government wants you to give to charity, right? They're incentivized to keep this around. I want to double click on the tracking error in this tax loss harvesting.
Why is tracking error a feature and not a cost? Well, in direct indexing, you might call it a cost because in direct indexing, remember, there's typically a 1% tracking error. And to reminder, direct indexing is just when you buy the long stocks to replicate the index and you tax loss harvest whatever goes down..
That's typically about a 1% tracking error. And it's uninformed, meaning no one's trying to beat the market or whatever it is.
It's just, I'm trying to track the market in a tax efficient way. So that might be a cost.
The reason in these active strategies, it might be a benefit is that if these managers are able to exhibit manager skill and outperform the benchmarks, then you're going to not only have better after-tax returns, you're going to have better pre-tax returns. I am very cautious.
I'm an efficient markets guy. I believe markets are pretty efficient, but I know there's inefficiencies, some, and I'm willing to take that risk and for that opportunity within these strategies.
So that would be the feature is you might beat the market, right? And not randomly because the manager did a good job. Said another way, if there was no manager selection, it was just long 2x, short 1x on the S&P 500, it would have the same return as the S&P 500.
Correct. But now we're unpacking it and owning individual stocks.
And I'm long this company and short this company. And I'm extra long this company, right? If too many of your bets go wrong, you could have a really adverse outcome.
But essentially, you're still next long. There's not think leveraged.
They think levered. And they think an 8% loss could be an 80% loss.
So why is that wrong? Yeah, because you're so we think about it in net exposure. Now, if I was long 2 million of Apple and short 1 million of Ford, that wouldn't really work here because it's so so you have such high concentration in two names.
But in a strategy like this, when you're willing to take leverage, you start talking about hundreds, thousands of names. If I'm short 800 names and long 900 names, and yes, I have a higher gross exposure, the individual position level details are not going to blow up a portfolio.
So we feel a lot more comfortable given the massive amounts of diversification that are used in these types of strategies. So you're not, yes, you've owned 2 million of stocks, but you're short 1 million of stocks.
And it's not just a couple, it's hundreds. So that diversification really brings your net market exposure back to that 1 million.
And also the managers have some concentration limits on industries. They're more likely to short Ford, go long, General Motors, or the opposite.
Individual name concentration, sector concentration, they have every incentive to do a great job here, right? Especially when it's a management fee only product, right? Where there's no performance fees, you know, management fee only product, how do you make money as a manager? You keep those clients there for a long time. You've got to deliver on what you, what you know.
That's an interesting thing about performance fees is sometimes it might incentivize people to take excess risk to generate those. But in a strategy like this, what I love, I love that it's a management field.
Just to play devil's advocate, if it's truly about the net exposure, why don't you advise everybody to go into 300 long, 200 short or a 900 long, 800 short of such product? There's limits to how much leverage you can take. And these are regulatory limits.
There's some in custodial limits, the custodians themselves, right? But then let's say you're taking a high tracking error. I don't want to underperform the market by 10% one year or 8%.
Because once you start going to these higher lever strategies, you're taking that more tracking error. And while you have the potential on the upside, I'd rather be closer to what the market return is.
Tell me about the tax management around it. Does it require family offices to really spend a lot of tax management or is it a simple 1099? Simple 1099.
This is done in your custody account, traded for you. Just the transparency.
To me, this is a phenomenal approach for investors and it's easier to report, easier transparent, better transparency, decent pricing. I think it does not require intense tax management.
Let's talk about private credit. You're very bullish on private credit.
It's obviously a very hot asset class. Why are you so bullish on private credit? First, I hate all the media stuff about it.
I'm a believer in the asset class. And we've been using private credit for eight, nine years now, significantly.
Well, we only started our firm in 2013. Basically, within a year, we were using it significantly.
If you go back to the year 2000, and you look at historical returns, public equities have done about 9% per year. Private equity has done about 14% per year.
Flip it over to credit. Fixed income has done about 3.5%, 4% per year.
Private credit has done about 9% per year. That's over a 20-year plus period.
So these markets, just being in them, you don't need to be with the best manager. Definitely don't want to be with the worst manager, but if you just get the return of these markets, it's very attractive.
Now, there's a lot of talk out there about all this money being raised in private credit. Is it a bubble? And I talk to people who say yes all the time.
I'm not in a bubble saying there's no risks. There obviously are risks, but what do we look at to make us more comfortable that private credit's not in a bubble? And when I'm talking about private credit right now, I'm talking about middle market direct lending, which is about half of the entire private credit market.
These are senior secured loans to EBITDA positive, typically private equity backed businesses. What would army if private credit was raising money much faster than private equity was, but that's not the case.
We're able to over time on an annual basis, see how much money was raised in private credit, how much money was raised in private equity. And that ratio has stayed pretty consistent over time.
Yes, a lot of money was raised in private credit, but guess what? A lot of money was raised in private equity as well. And this capital is being used to finance that.
Next, spreads. What a spread means is these are typically floating loans based off of, you know, what used to be LIBOR and now it's SOFR.
Let's say spreads might be somewhere historically between five and six and a half percent over the reference rate, half to five to six.5% plus the SOFR rate. If you had too much capital chasing too few deals, you would see that spread start to go down to 500 or 50 or 100.
We are not seeing that happen. Spreads get tight, spreads go wide, they fluctuate, but they've consistently remained within the historical band.
The next would be leverage levels. Now, this one's a little trickier because back in the, like, call it 2000, in the post-GFC, most of these loans were structured where you had a senior and a mezzanine loan right on top.
And so leverage levels for the senior piece might have historically been closer to three and a half. Today, that loan is typically being packaged together in what they call a unit tranche, where those leverage levels are closer to 5X, 5 to 6X EBITDA.
But they've been pretty consistent for the last five years during this time period where we call it the wall of worry has been going on about private credit. I remember seeing an article, I think it was 2019, I think from the Financial Times, and it compared private credit to fentanyl.
And it was 2019. We're now in 2025.
And investors who ignored that and stayed invested within the private credit markets have been experiencing north of 9.5% per year over that time period. You go after that EBITDA positive private credit.
Are you disciplined around that? Is that a specific thesis on that type of private credit? We are not a lender, right? We are allocating capital to managers in the space. The majority of the exposure we have is to call it like the middle market direct lending, EBITDA positive companies, typically 75 million on average of EBITDA.
Not 75 million of revenue, 75 million of EBITDA. These are big businesses.
There is a whole other world of private credit that includes venture debt, MES debt, real estate financing, like bridge loans, now GP financing, right? General partnership financing. We're not afraid of investing in those asset classes, but it's got a different risk return.
You got to get paid to do that. The big one that everyone's now talking about is asset-backed financing.
And all the big middle market direct lenders also have a business doing asset-based finance. I've spoken to a couple of institutional investors, and that's kind of how they're hedging the private credit space, thinking maybe the bull run could be over at some point.
They're transitioning into asset-based credit. To me, a bull run would mean you had outsized returns.
What's unique about this is these are just loans, right? This is a loan with an interest rate. And my upside is I get my interest rate.
And so me personally, I don't think that this has been a bull run frothy market. I think it's just, we just got the returns we expected.
The fault rates didn't go crazy high. The good managers had lower default rates than the market.
It performed exactly how we expected. Now, some people might hear this and say, well, it's about to change.
Personally, I don't think it will, but we're watching it. We're watching spreads.
Now, on the asset back side, I would say it's a compliment, and we would not make a wholesale shift over to the asset back side. The asset back side is interesting, but a lot of the asset back stuff is tied directly to consumer-based finance types of things like Klarna, just getting announced that they're going to go file for an IPO.
They have all these little microloans, right, that they do. They might securitize that and that could be called an asset-based loan if someone buys that.
But it's really tied to the consumer. And I do worry that if the shoe drops in the economy, it's probably the consumer first.
Now, our economy is 70% consumer. So that eventually flows through to the corporations as well.
But I am a little nervous about this rush to the asset-based space right now. And it could be that I need to learn more.
I just want to be clear, we are using it, but I'm not as bullish on this transition. You don't believe there's a bubble because it's not that asset prices have ballooned like real estate or S&P 500.
It's just that people are paying back the money. So it's not this increase in asset price that becomes unsustainable.
I would say what's happening is everyone's talking about a bubble because more money is getting raised there, but we are not seeing cracks. Now, we watch it.
They might show up, but you got corporate balance sheets are strong. And you know what's interesting, David, is we did get nervous when interest rates rose that, okay, a company that was 5X levered borrowed money at, call it 7.5%, right? Sofer plus, call it 5.
All of a sudden, Sofer goes north of 5. That company's borrowing costs nearly doubled, right? North of 10.
And we were nervous, right? And we absolutely saw defaults, but they still were below historical averages. Companies were really able to weather the storm that kind of occurred with that rise in interest rates.
I'm comfortable, but I'm not blind. I'm watching.
You mentioned GP lending. This is a more speculative, but presumably high returning asset.
Talk to me about GP lending. So general partners for the last, call it decade, have started to explore selling part of the general partnership to raise money.
And this money was used for things like committing more money to their next fund, buying out partners, stuff like that. And a general partnership of a private equity firm or alternative asset manager, they make money in a couple of ways.
One, they make money on management fees. They make money on carried interest when their funds do well.
And they make money on the money they put into their own funds. Typically, a manager will put in anywhere from three to 10, call it three to five, but you see some managers do more, three to 5% of a fundraise that they do of their own money.
That means manager XYZ raises 10 billion for their fund, right? They might be putting in, you know, a very sizable check of $300 million. That's a lot of money.
Where's that coming from? As these firms were raising bigger and bigger funds, they needed something to get more liquidity. And so the GP staking business really emerged.
GP financing has now kind of been a new way where, well, instead of selling an interest in this, let's take a loan with some contractual cashflow terms. That's basically a cheaper cost of capital for the general partner.
The next would be, you've heard about secondaries. Let's say people selling off stakes in their private equity funds and stuff like that.
That's parting ways with the economic interest. GPs are also now helping their limited partners gain liquidity on their underlying funds by bringing in some of these same players that will provide financing to provide liquidity.
And that new investor might get the first 14% of return going forward on the funds, and then they'll split it going forward, where that investor maybe didn't part ways with their entire position. It's a rapidly evolving, very interesting space.
And there's some firms really at the cutting edge of creating solutions to provide capital to general partners, whether for a stake directly to the general partnership or to the funds that they manage. Some preferred return than some share of the upside.
Exactly. Tell me about interval funds.
I know we both spent a lot of time on this part of the market. Why are you excited about interval funds? Again, industry innovation.
Look, there are people who disagree with me. I am a big believer that for certain types of assets, these registered funds, and the interval fund is one iteration of that, is a phenomenal product.
Funds basically are SEC registered, transparent. Everyone talks about no transparency in private credit.
Well, these managers that are listing these registered funds and interval funds, every single loan is public information. So to me,

that's pretty transparent. I think that's good for investors.
And these things price daily.

You can buy them daily on the interval fund side, and you can sell at periodic intervals.

That's why it's called an interval fund. That allows managers or advisors to much more flexibly

mold portfolios and have flexibility to change their mind. Now, people will say, well, you know, they're not liquid.
You know, if everyone runs for the exits, you know, then you're not going to get your money back. That's true.
It's absolutely true. Typically, a fund will allow 5% of the whole fund to redeem on a quarterly basis.
So if there's a billion dollars in the fund, 50 million can get out every quarter. If 100 million that quarter says they want their money back, they're not going to give it to them.
They're only going to give that 50 million. So everyone who put in for redemption will get half of their capital, 50 over 100.
That's a great solution. You don't want these managers being forced to sell illiquid assets at potentially bad prices.
It hurts everyone in there. That's a collective protection for everybody keeps everybody from losing money, especially those people that don't liquidate.
Exactly. And so, you know, a couple of years ago, if you remember, the redemption started in two major real estate funds, and every single financial press was writing about how terrible it was.
To me, I was like, this is great. It's working exactly how it should.
They are not letting people take all their money out and forcing sales. And while real estate market's been challenged, those funds were able to, you know, kind of skate through that period and perform okay, right? The market just didn't do great with real estate since 20.
I've had a dream for at least seven years to create this 10-year HODL Bitcoin fund that would not allow you to liquidate your... Do you know of any interval funds that are owning Bitcoin? Not that I know that they're owning Bitcoin directly, but some of the interval fund...
One interval fund is in the venture space and holds some crypto-related companies, but I am not aware of a crypto-only interval fund. But I like what you said because I remember I had a client who bought Bitcoin a couple years ago.
And he's like, don't tell me about it. I want to own it for 10 years.
And he actually called last week and wanted to sell it. Well, yeah, that's, that's the problem is that you actually have to give up your governance to somebody else.
So an interval fund might be a novel way to do it. Yeah, it could, or you just put in a private fund.
But in general, I think this industry innovation of creating these products that are easy to use, 1099 reporting, you're buying into existing pools of assets so you know what you're buying, run by really high quality managers. I think it's great.
Now, will there be bad ones? For sure. Just like there's bad public equity managers and good ones.
Just like there's bad private equity funds and good ones. I just think that a lot of times everyone rushes to what the negatives could be, but those are correct.
But let's also make sure that we're talking about the positives and how this can be very beneficial. And you expect pretty much all private equity funds to have one of these interval funds over the next couple of years? Private credit, I think yes.
Pretty much already happened. If they haven't done it yet, I don't know.
Pretty much everything in private credit, yes. For core real estate, the answer is yes.
For secondaries private equity, where you're buying stakes in other people's private equity funds. So you end up with, let's say a typical private equity fund has 30 holdings and your secondaries fund has a hundred private equity funds in it.
You're talking about 3,000 underlying companies. That's appropriate.
So yes, in private equity secondaries, if you're a lower middle market private equity firm that manages a strategy that's six to 12 investments, it would be impossible for you to put that into a vehicle that provided periodic liquidity and regular pricing. So there's certain types of assets you can't do.
I met with a student housing developer this week. Their strategy is buy, build, or buy land, you know, buy land, build a property, sell it.
They could never put that into an evergreen structure. Too illiquid.
It's too illiquid. Yeah, it just doesn't work.
And part of it is, let's say that property sells, they got to redeploy it right away in these types of evergreen structures. It just doesn't.
And talk to me about fees. So I know a lot of these interval funds are management fee only.
So how do you think about that versus management fee and carry? So there's still some that are like, so in the interval fund structure, you can charge a percentage of net income. In the registered fund world, we're seeing, you know, management and performance fee.
I would say the trend in the industry is fees coming down. I'll give you an example.
There's a manager and this is like, I'm going to give you the example of the whole wide, like the whole spectrum here. So seven years ago, we wanted to invest in a private equity manager.
Love this manager, love what they were doing. And we go to them and they say $10 million minimum per investor.
Like, okay, you know, maybe we've got a couple of investors that might want to put 10 million into one fund, but not that many. No budget.
Fast forward to four years ago, next fundraise is going on. And they now have tapped into the ecosystem of like where the high net worths are accessing alternatives.
And now all of a sudden it's a $250,000 minimum. Same manager, but it's still a drawdown fund, two and 20 fee structure.
Now fast forward to in the next couple of months, this manager is going to be launching an evergreen private equity fund where you can buy into a already seeded portfolio of assets, periodic liquidity subject to limitations. And the fees are going to be one and a quarter percent management fee and a 15% performance fee.
So easier structure, more investor friendly, lower fee. All of these things happening in our industry are so powerful that I just think it's great for investors.
I think it's great for advisors. And then eventually, I think it will also be good for the general partners who recognize that this trend is happening and create product that is easier for people to use and continue the fee compression.
We talked about the undervalued part about interval funds. It's essentially like owning an index or a stock continues to go up.
There's no forced distributions for a taxable investor that they should sell their assets every 10 years in a 10-year fund. Ideally, you keep on compounding until you need liquidity.
So it both provides more opportunity to have liquidity, but also

gives you more choice in terms of deferring liquidity. It's a great point, right? If you're

in a traditional private equity fund, you're being forced to take those gains when they sell.

Now, on the credit side, these interval funds are spitting out ordinary income each year,

whether you take it or not. But in the private, the ones that have figured out how to do this in the private equity space, then yes, you're going to have a pretty tax efficient.
Aaron, this has been great. How should people get in contact with you? You can go on our website, Schechter Investment Advisors, and I'll be right there.
Call us, email me. Happy to talk to anyone.
I absolutely love what I do. I have a passion for this stuff.
I love to help people and happy to talk to anyone at any time. Well, Aaron, I think we've known each other for eight years.
We've together returned a hundred million to LPs through DraftKings Punch. And that's not a common thing that happens in venture returning capital back to investors.
So it's been a great ride and it's a pleasure to sit down and chat. Absolutely.
Thank you, David, for having me. And I love what you're doing with the podcast.

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