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

Alan Zafran, Founder & Managing Partner at IEQ Capital, joins to unpack how ultra-high-net-worth families and institutions think about risk, cash runways, GP selection, illiquidity, secondaries, LPAC governance, and portfolio strategy amid rising rates and sovereign debt.

Episode Transcript

(00:00):
Tell me about where IEQ Capital is today.
Well, IEQ Capital today is a registeredinvestment adviser with 260 individuals, eight
offices across The US with just under$42,000,000,000 of regulatory assets under
management.
And last time we chatted, we had thisinteresting conversation about high risk

(00:22):
tolerances and low risk tolerances, and yousaid that both of those could be liabilities.
Double click on why it's bad to have a high ora low risk tolerance.
Well, having a high risk tolerance means youmight throw away some of the simple, concepts
of investing.
If you, put all your eggs into one basket andthings don't work out, you could lose, the
totality for capital.

(00:43):
That would be an extremely high risk, and thatwould be foolish.
But conversely, people who sit far tooconservatively fail to, miss out greatly on the
opportunities to invest.
And the way easiest way to think of that isinflation raises your cost of spending over
time.
If you simply sit in non, in assets that don'tcreate a rate of return, your real purchasing

(01:03):
power, your ability to spend diminishes overtime.
The cost of eggs and butter and bread goes upevery year.
So you don't wanna have too much risk and youdon't wanna have too little.
You wanna find the right balance.
And one of these interesting things about risktolerances is that a lot of investors don't
actually know their true risk tolerance.

(01:24):
Typically, they say they could take more risk.
Tell me about how investors would go aboutidentifying their true risk tolerance.
Ultimately, David, unfortunately, experience isthe greatest teacher, as evidenced by all the
scars on my back from thirty six years ofinvesting in the investment management
industry.
But I think the most practical thing to do istake a candid survey of yourself.

(01:46):
You have to look at your spending needs.
You have to make sure you put enough cash asidefor rainy days and emergencies.
Common wisdom means that's anywhere from threemonths to one year's worth of spending needs
upfront to ensure if anything goes bad, youhave time to weather a personal storm or
challenge before you need to access yourcapital.
And then you need to think through what have Iexperienced in my in my life, if at all, when

(02:09):
things haven't gone my way?
Do I have the patience and self confidence orat least the confidence in what I've put my
money into that it will recover over time?
So the greatest, protector is to diversify byspreading your assets across a variety of
different things.
Any one event might hurt some of your holdings,but possibly not all of your holdings.

(02:31):
But this is learned through time and patienceand experience.
There's no magic formula.
All that we know is when you do put all of yourmoney into one thing, you're both creating a
greater opportunity for wonderful fortune, butalso calamity.
And the more you spread it out, the less likelyyou'll have a significant up or down move, but
you buy yourself greater latitude to weatherany short term challenges.

(02:55):
The way that I kind of look at it is observingmy own behavior, almost like I'm I've gone
outside of my body and observing myself, and II look at a certain situation and I sold too
early or I didn't sell soon enough, and then Iask myself why.
What kept me from that?
That's kind of how you build a self awareness,and you essentially start mapping out your own

(03:16):
true risk tolerance by actual behavior versusperceived behavior.
So how you actually act in certaincircumstances versus how you think you would
act.
I'd agree with that.
It turns out psychologists have actuallymeasured 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

(03:38):
as the joy from winning.
And so often what happens is individuals havean 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 ortoo much in a cryptocurrency or too much in a
venture capital fund or a private companyinvestment, there's any number of ways that can

(03:59):
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, orat least understanding how to moderate how much
money goes into any of those risky, singularinvestments.
So no one thing can unilaterally createterrible financial harm for you.
On double click on something that you said thatI think people will undervalue and that you

(04:23):
wanna have that three month to twelve monthrunway.
Another way that I would reframe that isactually having enough of runway or having a
safety to your portfolio can actually allow youto increase your risk tolerance.
And a lot of the reasons why people don't havehigher risk tolerance is they try to make every
asset play every position.
But by having your fixed income, let's say, ortreasuries be your safety net, you could

(04:48):
actually take more risk than the rest of yourportfolio.
I strongly agree.
Assuming, again, you're very clear about whatyou're using your investment port portfolio
for.
Do you need to draw upon it for income?
And if you do, is it a modest amount tosupplement your living expenses?
Or is it truly assets for long term savings?
It's even easier to think of in some respects.

(05:10):
If I know I have an IRA, a retirement account,and I have no intention of touching it for
potentially decades, I should have atremendously high degree of risk tolerance
because I have such a long term time horizon.
What you're alluding to clearly is when you'retalking about your own personal savings in your
individual account, or maybe there's a familytrust and you have to balance out you and your
spouses or partners, spending habits as well asyour own likelihood of continue to earn after

(05:36):
taxes certain amount of money that can maintainyour standard of living.
Having that extra cushion of balance of threemonths up to twelve months of cash knows that
if there's some short term event, it could be amedical event, it could be a change in
lifestyle, it could be an immediate need tomove, It could be the need for a new car.
A variety of things create these one timeunforeseeable cash drains.

(05:59):
And the question is, do you have enough cashsaved to weather those unpredictable events and
yet still sustain a real investment long termplan.
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 unforeseeableevents, medical events, changing, buying a new
car, moving to a different house.

(06:20):
It allows me to have a longer time frame forthe balance of those assets and then allows me
to take a riskier perspective because as youand I both know, more than I'm willing to tie
up my money in a longer term investment,history teaches us the greater the likelihood
that there is a positive outcome, even ifthere's a short term drop in the markets or
other financial prices.

(06:41):
So this might be a weird question askingsomebody that's running an RIA with
$41,700,000,000 but is there ever a case whereyou wouldn't want a client to be fully
diversified or leaning into specific assetclasses?
And if so, why?
We work with individuals and entities of alldifferent levels.

(07:04):
So the recommendations that we must give as afiduciary have to be beholden to their income
needs, risk tolerance, time horizon, age, andthe entirety of their life circumstances or
that specific entity's needs.
There could be occasions where an entity, as anexample, is a small percentage of a much larger

(07:25):
portion of someone's capital.
An example might be someone has a very smallIRA account in the context of a much larger
state.
In that instance, if they are truly, prone torisk, they may conclude, as an example,
investing in private credit, which is not taxedwithin a retirement account and currently yield

(07:46):
something in the order of 10%.
They might feel inclined it's better invest allof their capital in the retirement account in
one or two private credit funds because it'sjust a piece of a much larger puzzle.
Yet from a tax efficiency perspective,investing in a private credit vehicle in their
IRA is avoiding current taxation on theirincome.

(08:08):
And they view that as just part of theaggregate allocation, and therefore they may
not invest any private capital in the totalityof their taxable holdings.
There are a number of other examples we couldwork through, but it comes down to each
individual's totality of their holdings and howthey view each component that leads to
potentially taking on greater degrees of risk.
But they need to understand when you're takingthat concentration, there is an element of

(08:32):
greater concern that may not, may not work out.
And you mentioned private credit.
You guys have quite a bit of private credit inyour individual accounts for 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 toinvest in private credit for the for the tax
tax aspect of it.

(08:54):
Start from a concept that we believe thatthere's something called an illiquidity premium
to be, gained by an investor.
The idea is if you buy something that can bebought and sold on on any daily basis, which is
a stock, a bond, or an exchange traded fund, amutual fund, you get a certain rate of return.
To the degree, you're willing to invest inwhat's called a private credit vehicle or any

(09:15):
vehicle that doesn't trade on a daily basis.
We believe as a result of that condition, youshould be earning something higher, all things
equal, than an equivalent credit that can beaccessed or sold on a daily basis.
That term is called an illiquidity premium.
There are a large number of academic studiesthat talk to there is this premium both for

(09:37):
income generating assets, which we often callprivate credit, and also for growth oriented
illiquid investments that have a variety ofnames often known as private equity.
And so we believe private credit is anattractive asset class if it's invested with a
manager who is investing in literally dozens,and frankly, more likely hundreds of underlying

(10:00):
loans so that no one single loan to oneunderlying borrowing company is likely to
materially hurt your returns.
Used to be tied to something called LIBOR.
It's now called so far, the structuredovernight finance rate.
Market conditions vary over time, butoftentimes a senior floating rate loan to a

(10:20):
company that's private and is borrowing money.
The rate of return that you, the investor mightearn on that single loan might be something of
the order of that structured overnight financerate so far, plus anywhere from five and a half
to seven and a half percent.
So we can talk about in a moment why we'dprefer it sits in some kind of nontaxable
entity, like an IRA or other retirementaccount.

(10:41):
And yet when I am a lender, in the eventthere's a problem with a company, I as the
borrower, the lender have the first claim onthe 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 afund or with a manager that runs a fund who
hopefully has hundreds of loans, and evenbetter, to the degree they can be loans made to

(11:06):
private companies that are positively cashflowing, positive EBITDA, it's called, and even
better to the degree those companies are oftenowned by a private equity firm that has on its
own validated and underwritten the financialsthat underlie the private company, I end up in
a position where I am lending money to upwardsof several 100 companies in one basket.

(11:29):
And if anyone or two or three companiesdefault, first of all, that won't unilaterally
take down the totality of the investmentmaterially.
Secondly, because I'm the senior lender, I havethe first call on capital when there is a
workout.
Thirdly, the historical rates of return onthese assets, even including incidences of

(11:50):
defaults and losses, tends to be still in thehigh upper single a high single digits or even
low double digit return percent, net of alldefaults and losses.
So it's historically been an attractive riskadjusted rate of return asset class, and it is
best suited in nontaxable accounts, charitableremainder trusts, family foundations, donor

(12:12):
advised funds, 401ks, retirement accounts,IRAs, Roth IRAs, so inherited IRA accounts.
So what we do at our firm is in the context ofproviding advice to the degree clients want to
access income generating assets as part of adiversified portfolio.
What we do is we focus on those accounts thataren't subject to ordinary income taxation and

(12:35):
say private credit is among one of manyilliquid strategies that we might utilize to
help you build a well rounded, well diversifiedportfolio.
What we don't want to do is put all of thatprivate credit into one loan to one company.
That's too much concentration in one thing.
So again, we're diversifying by the asset classitself.

(12:56):
And then within the asset class, diversifyingacross one or more funds, each fund of which is
spreading out the loans across dozens orhundreds of underlying companies.
So for these very reasons, there's a lot ofpeople investing in private credit, and there's
a concern that it might get overheated justlike any asset, what would be the leading
indicators that there might be too much moneyin private credit chasing too few

(13:19):
opportunities?
Well, I don't know if it's too much creditchasing too many opportunities given the size
of the market.
I think the greater, increment is what happensis all things equal.
The challenges in these companies is they areborrowing money, and it's dependent on their
ability to generate earnings before interestand taxes to pay you back.
So they are subject to the whims of a softeningaccount.

(13:42):
So the signals are less about how much money isflowing in relative to how the size of the
market.
The size of the market is enormous.
The challenge is if you truly believe you areentering into a softening economy or really a
recession, the likelihood is the revenues andtherefore the earnings before interest and
taxes that these companies are generating isgoing to diminish.
And the likelihood that some of the underlyingcompanies will default on their debt payments

(14:06):
will go up.
It turns out this asset class, even weatheringthrough previous recessionary periods, has
still performed reasonably well.
And typically, the actual losses incurred andrecoveries ultimately be a much better outcomes
than what gets penciled out.
But it is, in fact, where the asset classitself gets challenged because most managers

(14:27):
must do something called mark to marketaccounting.
So if you're a manager and you own a privateloan, even if you believe the company will make
its payments to its maturity.
And in fact, even if the company is performingwell, accountants will require that they mark
each quarter, typically, the value of the loanif they were to sell it.

(14:47):
Even if they were to have no intention ofselling the loan, if publicly traded high yield
bonds are falling in value, privately heldloans will be forced to mark to market their
valuations lower.
So it will signify, at least on a client'saccount statement, that the value of the loan
that was extended to the private company hasfallen in value.

(15:08):
What you wanna make sure is you are in a poolof loans with a manager who has the discipline
to understand fundamentally what's transpiringwith a company and whether fundamentally can
make payments on its loans through arecessionary cycle to the endpoint, rather than
panic and sell at the wrong time and be forcedto sell the loan when it's being marked to
market down because of what's happening awayfrom the portfolio in the broader high yield

(15:33):
publicly traded bond.
Presumably there would also be a secondaryopportunity there where the asset is marked
down, but there's still an ability to pay outthe loan.
There would be and in fact, it's anotherterrific asset class.
So it turns out amongst the many asset classesthat we do direct some of our client capital
to, it's an illiquid investment, meaning itdoesn't trade daily is the history of being a

(15:58):
secondary investor buying an illiquid positionfrom the initial primary investor, oftentimes
at a discount to its real inherent value is atrue in a terrific strategy.
That we do that on behalf of clients in avariety of asset classes, one of which is
credit.
So we will use a manager who has expertiselooking for limited partners, owners, primary

(16:21):
owners of these credit funds who, for variousreasons, need money today and are willing to
sell their illiquid private loans to privatecompanies at a discount to their inherent
value.
And when that sale is being made at what weperceive to be a materially lower price than
its true inherent value, its net asset value.

(16:42):
To that vein, there's famous investors likeWarren Buffett that hoard cash for these
dislocations in the market where they go in andbuy assets cheap or do convertible equity.
Do
you
have allowance in your strategy for beingopportunistic during market downturns?
And how does one actually operationalize thatstrategy as an investment strategy?

(17:06):
It comes down having your own investment policystatement personally to begin with, and you
have to decide whether it's prudent topersistently hold some amount of cash for
opportunistic investing.
It is challenging.
And the reason it's challenging is it'sdifficult to time markets.
And if you think an opportunistic investment isgonna come quickly to you, the problem is it

(17:26):
could take much longer than you think andsitting in cash, whereas it might have been
invested elsewhere is hard to do.
So what we aim to do with clients is make surewe have an alignment, a strategic asset
allocation.
They can conclude whether they wanna hold somecash for potential opportunistic moments in
time.
What oftentimes is done is looking at an assetallocation and making marginal decisions.

(17:48):
Rather than sitting with cash, which couldpersist for years, we think it's better to be
pretty fully invested, but I'll always belooking on the margin if one relative strategy
pencils out better than the other.
And if the transactional and tax related coststo make the changes are warranted, then it's
worthwhile pursuing.

(18:09):
If you can't make the tax related andtransactional related related costs worthwhile,
you might forgo those opportunities.
It is incredibly hard to be an opportunisticinvestor because it's exactly the time things
look so horrible that you're afraid to investis exactly the times you might jump in.
If you look at just as an example, what'shappened to stocks this year.

(18:30):
We had an incredibly rapid decline in theprices of global stocks and an incredibly rapid
rally.
Had you not been dollar cost averaging into thedrop or brilliant in your ability to pick the
bottom in early April, you might have beensitting in cash and thought it was going to get
worse and never put the money to work like youthought.
And here you would have been at the July, earlyAugust, and you still haven't gotten your cash

(18:54):
put to work.
And so we actually think you're better todefine what your real long term strategic
target asset allocation is.
Get to that allocation, and then make marginaldecisions as opportunities arise to determine,
is there on the margin at that moment a betteruse of the capital?
And again, that strategic allocation caninclude cash for rainy days, emergencies, or

(19:19):
opportunistic investing if that is your purviewand you're willing to theoretically lose some
of the upside to know that you can gainfullyjump 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 gonna have to get at least a 50%

(19:42):
discount when that market dislocation happens,assuming that you have the boldness to go in
with that bet.
So it's I've always wondered how people timethat market, but reallocating resources and
reallocating asset allocation, maybe you takesome off of public and you find that publics
and privates are down on that.
They should be at about the same levels you seethat arbitrage.
That that makes more sense.
That's right.

(20:03):
I think it's very hard, especially when you ifyou're gonna use stocks as your benchmark,
Albert Einstein, I think, said the eighthwonder of the world was compounding.
And so, but, you know, I don't I have a littleknown statistic, but apparently Warren Buffett
made 99% of his wealth after age 65.
And it's due to the power of compounding.

(20:23):
He built a savings to a certain level.
And if you've ever heard of something calledthe rule of 72, it roughly means if, you want
your money goes up 10% a year, it doubles everyseven point two years.
And so the power of compounding is verysignificant.
And if you miss out by sitting in cash, earningmaybe 4% a year pretax, you're gonna have a

(20:45):
really hard time two and a half percent aftertax compounding and catching up with the power
of stocks.
That's why opportunistic investing is fraughtwith a lot of risk, and someone needs to really
understand getting back to one of yourquestions about not having enough risk on by
missing out on assets that typically grow overtime, an unwillingness to take on risk, there's

(21:07):
the unrecognized risk that you're not keepingup with inflation, you're not building enough
savings for one day when you choose to retireand rely on your portfolio to support your
standard of living later in life.
What's the saying, I've predicted five of thelast two recessions?
That's exactly what Or you know what you knowand you know what you don't know.
It's what you don't know that you don't knowthat will hurt you.

(21:30):
And to that vein, I wanna be clear, I'm notcalling you old in any any regards, but you you
have had a very long and illustrious career.
And I often think about this concept of thecompounding of relationships, the same, like,
compounding money.
Have you found, like, in the last five, tenyears, your relationships have really
compounded, or has it been more linear?

(21:51):
My relationships have compounded.
I think your what happens is your circles andnetworks expand.
By way, thanks for illustrious.
That's a great term.
I think if you put on glasses and you startgetting your hair gray, you get a lot of
accolades in these businesses too.
But I wouldn't lose sight of the importance ofa one on one relationship.
I mean, at the end of the day, you I mean, I'mblessed to have a large number of

(22:14):
acquaintances, you can only truly have so manyfriends no matter what.
But the value of sitting on this side of theinterview with you.
Being in the business of service of servicingthat client is everything.
If you don't really have empathy, if you reallydon't care about the underlying client, you're
you know, you shouldn't be in wealthmanagement.

(22:35):
So this business starts with clients doing theright thing for clients.
And it's incredibly gratifying to feel that weenable clients to feel more comfortable with
their wealth, to try and accomplish their ownpersonal goals from a from a lifestyle
perspective, even a philanthropic perspective,or a transfer of wealth to the next generation.

(22:57):
So really trying to get to understand peoplereally understand what are their primary
objectives?
What is it they're trying to avoid, and alsotry to coach them in a way to be prudent with
their capital, thoughtfully take calculatedrisks in prudent way.
It's a really powerful dynamic, and it's reallygratifying.

(23:18):
That's why dinosaurs like me stay in thisbusiness.
I found, especially in the ultra high networth, there's a lot of skepticism.
So sometimes you need time in the ground.
You need to build credibility over manydecades.
They say reputations are built over decades,lost overnight.
Certain things and certain relationships canonly be built over decades, cannot be built

(23:40):
over months.
It still takes certain types of relationshipstime to season.
Yeah.
I think that's right.
And and we're we're a service business likemany other service businesses.
We're only good as our last client.
We're only as good as our reputation, and we'reonly as good as giving thoughtful advice that
can last for a decade, not just quick fixes.
41,700,000,000.0 AUM, a couple 100 clients, youcould kind of do the math and a lot of these

(24:05):
people are the ultra high net worth.
In what way do those portfolios differ for youfrom endowment style, say a Harvard DL, name
your endowment strategy?
Well, it's funny because we do like to fashionportfolios that do take advantage of this
illiquidity premium like an endowment, but thethe singular difference is individual families,

(24:25):
at least most of their entities, are taxable.
So the number one thing we have to do is takeinto 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 inhigh tax states.
Secondarily, a lot of individuals spend a lotof money.
So it turns out not only are you getting taxed,but it turns out there are, we have to account

(24:49):
for people's cash needs and cash flows.
Thirdly, many of the, individuals we work withhave a wide variety of invest investment
interests that span into private markets,whereas they're, investing in private companies
that have repeated rounds of fundraising, orthey might invest in variety of illiquid
investments where capital is drawn in a venturecapital fund or a private equity fund over two,

(25:14):
three, or four years.
So we need to do some artful cash flowestimations for these individuals as well.
Lastly, and importantly, many individualsrecognize the importance of prudent estate
planning.
This means anything from proper amounts of lifeinsurance or disability insurance, so far more

(25:36):
complicated issues that are aiming to transferthe wealth to their next generation, but in a
way that might not steal the ambition of thekids, as well as tying in whatever
philanthropic interests that they may have.
And so all of those elements affect how youthink about investing.
You have to be prudent about how you'reinvesting, timing the cash flows, making sure

(25:58):
whatever strategies are put into place have theliquidity to meet capital calls and other
life's lifestyle spending.
So that impacts how we think about allocatingassets for taxable families that are individual
clients of ours.
Thing I've always wondered about is whathappens when a family office can't meet a

(26:21):
capital commitment has to borrow.
What are some tools available for the ultrahigh net worth when it comes to short term
needs for things like private equity calls oror venture capital calls?
That's a complicated question because it'll becase dependent.

(26:42):
It's funny.
Oftentimes, they don't have a they don't havethey're not calling the rich uncle because they
are the rich uncle, so to speak.
Solutions include, but are not limited to thefollowing.
First of all, there actually are someorganizations that will give consideration to
looking at a basket of illiquid investments andmight make a loan against that basket of
illiquid assets.

(27:04):
Typically, that loan is at a much higher rateof interest than what you would imagine.
But for example, if you were to borrow againststocks, bonds and mutual funds, you you might
borrow at a rate like SOFR plus 1%, which intoday's world might be five and a half percent.
Loans against private assets could easily bedouble that amount or more.
So that's one consideration.

(27:24):
Secondly, this is where we talked aboutearlier, secondary investing.
And maybe they're not going to be able to meetthe capital call, and they may have no
recourse, but to actually sell the underlyingprivate equity fund to a secondary buyer.
It's exactly the kind of opportunity that wetry to find on behalf of our clients.
A third possibility, and it's not clear, isthey may have within their estate planning

(27:48):
documents structures such that some otherentity has the capability to loan capital back
to them for a variety of reasons, whichliberally interpreted or literally interpreted,
depending on the documents, might enable themto borrow against assets in another entity in
order to actually meet the capital call.

(28:08):
So there are a variety of mechanisms involved,but it really comes down to the individual's
risk tolerance and time horizon to concludewhat'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 thatevery wealthy person is is basically highly
levered on these single stock loans.

(28:29):
How common are those, and what are some bestpractices around those?
First of all, I want to I don't believe that tobe true that most people are leveraging or
leveraging against single stocks.
I think that's a significant minority of thepopulation.
I just want to put that out there.
I also think secondly, when you're borrowingagainst an individual asset, whether it's a

(28:51):
stock, let alone some other asset, you'reputting yourself at pretty significant risk in
the event that stock or the other asset falls.
I think we all know what margin call is.
A margin call is when you might borrow againstthe value of a stock.
Say say you borrow $50 against a $100 worth ofstock.
Typically, the lending and organization seesthat the value of the loan is now 70% of the

(29:16):
value of stock, let's say the stock fell to $75per share from a $100 per share, and you were
borrowing $50.
If you're borrowing 50 and the stock is nowonly worth $75 the lender is going to begin to
get anxious.
There's not enough value in the stock toprotect the loan.
And if the stock continues to fall, the lenderhas the ability to do what's called a margin

(29:37):
call.
They call the borrower and say, either you needto put up enough money to get back to a $100 or
we're going to immediately forcibly sell thestock at this low price, 75 or lower and hand
you back what's left after we collect our $50plus interest.
You don't want to be on a margin call.
You don't want to have your loan or stockunderlying asset forcibly sold at the worst

(29:58):
possible time because you don't have theability 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 orwhoever else has this point of view that
leverage on occasion can indeed be prudent.
If you believe your borrowing cost issignificantly lower than what you can earn by

(30:21):
putting your money into another asset, And inthe event you're not putting yourself in undue
harm and putting your point at risk ofeventually being put into a margin call
situation, you might decide that it's worth thewhat's called arbitrage.
Arbitrage is the rate of return you expect toearn, which will be higher than your borrowing
costs.
It's also prudent on occasion to borrow becauseyou could be in a situation where you have a

(30:44):
short term, somewhat arbitrary cash flow need.
So as one of many examples, imagine you had amillion dollars in a stock portfolio and its
cost basis literally was $300,000 you might bein 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

(31:04):
go, but you need to pay your bills.
And let's say you don't have any cash in yourbank account.
You borrow against the value of your milliondollar stocks for three months than to sell
some of the stocks and pay a large capital gaintax just for the sake of raising cash,
especially if you knew you had the other joblined up and ready.
So I can give you examples where borrowingmoney, particularly if you have discrete short

(31:28):
term timeframes, you can identify the nextsource of income to offset the borrowing, it's
prudent.
But to think that someone should just wreck, Idon't know if recklessly is the right word, but
aggressively borrow against assets to amplifytheir wealth.
That's a lot of risk.
And that's something typically we would not beterribly comfortable.

(31:50):
So tell me about your philosophy when it comesto picking GPs.
What's the right vintage or right size of a GPand how do you ascertain that within NASA
class?
So picking GPs is somewhat art as much asscience.
So what we aim to do is we look for an assetclass we find to be attractive for a number of

(32:12):
reasons.
We obviously interview a large number of GPs inthe space.
What we look for in GPs is a variety offactors, including but not limited to the fact
that typically there's a team approach.
So there isn't just one star, not a reliance onone key man or key woman.
Secondly, we want to see that whatever strategythey are deploying consistent with what they

(32:34):
have done historically because that gives usconfidence that they have a lot of pattern
recognition and know exactly what this Thirdly,what we wanna do is we wanna examine their
prior funds and see if they've had anythingcalled style drift.
So an example of style drift would be you toldme you invest in private companies in the
technology industry.

(32:55):
And if I look at your prior company, youinvested in technology and companies that were
in the health care industry.
That's style drift.
When a manager, a GP comes to us and says, weare going to be a technology private company
investor.
If I see in their previous funds, they in factdidn't do that.
They drifted away from the style they said theywere going to follow.
That is a significant negative on our factor,because we therefore would not have assurance

(33:20):
that they would follow the mandate they'reproposing to do in a new phone.
So if I get to the point where there's a strongreputation of the manager, there is not a
single key woman or key man risk, They have notdemonstrated any style drift.
We then look at how much capital they'reraising in this specific fundraise relative to

(33:40):
the sizes of the funds they have raised in thepast.
If we find that they're doubling the size ofthe fund in the new fund, and if they haven't
hired any number of material senior people tomanage the portfolio, it raises a question as
to why are they raising twice as much money asthey did last time, unless they have enough
individuals to support raising that amount.

(34:01):
So we look at the relative consistency in thefundraise or the degree which the fundraisers
are increasing.
There's too much money being raised in thesubsequent round for the same opportunity, and
if they haven't materially staffed up theunderlying team to support that amount of
capital, we put to question why that's allhappening.
Once we get past all of that, we then canassess whether that team has in fact invested

(34:27):
prudently in the strategy they're going to, theamount of dollars they're investing is
appropriately sized relative to the totaladdressable market.
And then we can look at things like trackrecord 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 moreimportant because in some respects, the track

(34:48):
record is the byproduct, having the right teamwith the right amount of money focused on the
right opportunity set at the right time.
All of those elements jump into how we thinkabout finding the right general partner.
Said another way, the track record ishistorical.
It's lagging.
It's good if it's great, but what you're sayingis the leading indicators.

(35:11):
How will the franchise perform in the future?
Things like teams, style drifts, fund size arelead are leading indicators, and the track
record just is lagging indicator.
Track records are important, but they can bemisleading.
So when we look at track records, we begin tobreak down the previous funds.
And how are their returns earned?
So I'll give you examples.

(35:32):
Whereas in venture capital or even growthequity, 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, forexample, in a private credit fund where you'd
want to see much greater consistency ofperformance across all the loans.
So what you're doing with the track record isyou're teasing out the where the returns came

(35:56):
from.
You try to determine if it's possible whichindividuals you can attribute each piece of the
returns they came from.
You also want to look at the vintage, and youwill want to look at the vintage, the year in
which the fund was created, relative tocomparable funds in the same year, it turns
out, the vintage or a year in which you chooseto invest for many asset classes is as or more

(36:22):
determinant of the returns than the actual teamyou gave the money with.
That's particularly pronounced in moreaggressive strategies such as private equity,
venture capital and growth equity.
It's a bit less pronounced in things likeprivate credit.
But we try to look backward on track record,both absolutely getting down into the details
and then prospectively and comparatively backout to the broader universe.

(36:47):
A lot of these diligence items you're statingas fact patterns, but even these facts are not
a 100% known.
Sometimes they need to be corroborated withreferences.
That's kind of the the thing that gluestogether the mosaic of information.
Style Drift, all these things could only beknown if somebody was an investor at that time
or working with them at that time.

(37:08):
You could always paint a narrative that showsthat that that's kind of what you were always
thinking.
That's right.
So an important component of any investigationof a fund is talking to a handful of investors
who are in the fund.
And what's best is not just the two or threethat the fund or GP tells us, but to do our own
independent research and find other LPs orinvestors in the fund that they didn't tell us

(37:30):
about.
So one thing you can do is you go to theunderlying manager and you ask for three
references and you go to those threereferences.
Then you go back to the underlying LP or GP andyou say that those were great.
We want three more references.
Try and dig down another layer.
Another thing you should know that's alsohelpful is when we are talking to other
institutional investors, it's terrific to havea conversation not just about the fund itself,

(37:55):
but other funds and strategies they arepursuing pursuing.
So oftentimes, some of our deal flow or the wayin which we source opportunities is by talking
to, likewise, sophisticated institutionalinvestors and identifying both asset classes or
themes as well as specific managers whom theyare investigating.
It leads us down other investigative paths thatmight lead us to other investment opportunities

(38:18):
for our clients.
We discussed these facts on the ground, theirtrack record, style, team, returns, vintages.
There's also a art to it, which is I'm gonnause the verb vibes, but more like relationship
with the GP and how you get along with the GP.

(38:38):
Why is that important?
It's very important to have a relationship witha GP that's trusted and transparent.
There's a fine line between having completeaccess to information in a way that we can
objectively evaluate it as completely andwholly as possible, relative to having what's
called the endowment effect, where I sourced aninvestment, I'm beholden to that investment,

(39:02):
I've developed a friendship with that GP, andsuddenly I'm biased positively towards that
fund.
And therefore, I'm giving them greaterforgiveness for things they might be done that
I wouldn't like either the returns aren't asattractive as I thought they might be.
Or they might change certain terms relating tothe limited partners or clients that would be
less friendly to the LPs.

(39:23):
So it, whereas it is critically important tohave a strong, trusted relationship that's
transparent with a GP.
It's a fine line between that and a friendshipto the point where it can befuddle or muddle
your ability to be objective, becauseultimately, we're fiduciary for our clients.
So we knew and should keep that in mind at alltimes and ensure that we continue to be a very

(39:46):
mindful fiduciary.
Should know, as a matter, of course, on roughlythree quarters of the illiquid investments in
which we have invested, and I believe thatnumbers to roughly 200 vehicles over the last
ten to fifteen years, We have been on what'scalled a limited partner advisory committee,
LPAC, roughly three quarters of the time wetypically demand when we invest with a fund

(40:12):
manager, we want to be on the LPAC.
The LPAC is sort of this convention that worksfor both parties.
The general partner likes to have the three orfour or five largest and arguably most
strategic investors well informed because thatgeneral partner is hopeful that those same
three, four or five large investors willreinvest when they come up with a new fund.

(40:35):
So they're trying to make sure those limitedpartners are well informed.
Conversely, we, the limited partners, want tostay on this L PAC for two reasons.
One is we absolutely want to have as much andup to date information as possible to ensure
that we can keep our underlying clientsinformed.
And secondly, to the degree we can have anactive voice and to the degree we can

(41:00):
articulate limited partner client friendlypolicies, procedures, better reporting, better
packages, more frequent communication.
It's our mechanism to communicate that to theGP to create a better client experience.
So whereas we won't make investments, the GP ismaking the investments.
We're trying to ensure that the informationcoming is consistent with our expectations,

(41:24):
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 smoothcommunication.
So we aim to be on the L pack are typicallyabout three quarters of the time.
And that's the mechanism to try and keep the GPrelationship trusted, transparent, healthy, but

(41:45):
still client centric.
You seem to have mastered this, the art ofkeeping good relationships while having good
governance.
What's the key to that?
And tell me how you manage those two somewhatconflicting drives to want to be the GP's best
friend, but also make sure that they're doing aright and professional job.

(42:06):
Well, general partners have to raise capital inorder to run their funds.
So, they're gonna work hard to ensure that weare well served.
We at IQ Capital typically will invest a$100,000,000 or more of client capital into a
vehicle.

(42:26):
And so we're, we're deemed effectively be aninstitutional investor.
And therefore, GPs, that we are, an entity ifthey are able to get us to agree to invest in
their vehicle.
It's a lot easier than chasing a 100 investorswith a $1,000,000 capital commitment each.
So they have a lot of, interest in keeping ushappy.

(42:48):
Conversely, and to be clear, we're in thebusiness of working on behalf of our clients.
Just can't say it any other way.
We don't have a client.
We don't have a business.
So whereas we absolutely want to have healthy,strong, trusted relationships with the fund
manager, the GP, We can't lose sight of WeWorkas a privilege on behalf of the client.

(43:08):
And therefore, everything we do and must accrueto the benefit of the underlying client.
We take it personally because as we talkedabout, your reputation is everything.
Let's talk about the 800 pound elephant in theroom.
The debt.
I know last time we chatted, we talked aboutit.
How does one account for this growing nationaldebt practically in their portfolio?

(43:30):
So, it's a macroeconomic issue.
Right?
It's not gonna affect day to day what's goingon in my personal savings and spending account.
But at a macro level, you've got a realconundrum is The US 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 isbasically this.

(43:53):
David, imagine you came to me and you had$36,000,000 in debt personally, and you were
spending $2,000,000 a year more than you wereearning.
You said, hey, can I borrow any money from you?
I'm like, are you crazy?
You're 36,000,000 in debt and you spend another2,000,000 in debt every year.
I wouldn't give you a penny.
Well, you go to The US and it's got a$36,000,000,000,000 debt.

(44:16):
It's spending $2,000,000,000,000 a year morethan it's earning.
It can borrow money all day long.
Ten years fixed at 4.4%.
It's the same thing except the government hasthe ability obviously to raise taxes or
generate other forms of revenue.
So at a high level, there's only five thingsthat can be done when there's debt like that.
One is The US Government can turn to othercountries and say, will you lend us money?

(44:41):
Hey, Germany, will you bail us out like youbailed out Greece in 2011?
Well, no one's going to bail out The US becausewe're the biggest, financial entity in the
world.
So that's not gonna happen.
Secondly, we can sell our assets.
We could sell the Washington Monument and MountRushmore and the Pentagon, but we're not gonna
do that.
Third thing we can do is we can balance ourbudget, but it's pretty evident we can't

(45:03):
balance our budget.
I think Elon Musk just came in recently andtried 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 countryto lend you money like that, if you're not
going to be selling your assets and if youcan't balance your budget, you only have two
things you can do.
You can inflate your way through the problemwhere you default the way you inflate your way

(45:27):
through dollars.
You know, I owe you $36,000,000,000,000 I'mjust going to print more, more bills.
Here's 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?
I'll answer several fold.
First of all, it turns out The US is still byfar the most stable economic and political

(45:51):
system we have globally.
So until we find a better system, whether youthink 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 financialsystem to replace the US dollar, we are not
likely to see a change.
Therefore, investors will continue to fly intothe dollar and enable us to finance our debts

(46:15):
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 yourcost of borrowing.
So if we actually look at America's averagecost of borrowing across Treasury bills all the
way through long term debt, it's somewherearound 4%.

(46:37):
Turns out, if you look at our nominal GDP rateof 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 payoff our debts at 4%, you can actually sustain
this for quite a while.

(46:57):
This is why if you hear a lot of financial,figureheads, they'll argue that when you see
the ten year treasury bond yield getting upabove 5%, it begins to scare the financial
markets.
Scares the financial markets for two reasons.
One is the cost of borrowing is going up, andit's clearly a disincentive for corporations
and individuals to borrow money, which meansspending will drop and you're on the precipice

(47:21):
of potentially slowing the economy intorecession.
But secondly, it's a real problem because itsignals that at some point, the US government
won't be able to tolerate its borrowing costs.
What's happened in the past is every time thetenure is approached those levels, risk assets
tend to sell off.
It becomes a self fulfilling prophecy.
What happens is risk off risk off investors flyinto the US dollar and the treasury bond, and

(47:45):
it pushes the yields down and we reset again.
But as long as we're continuing to grow as acountry faster than our average borrowing cost,
this dynamic can persist for quite some time.
But there's this reflexivity that I think a lotof people don't appreciate in all this in that
if you started paying down the debt, the tenyear would go down and the cost of capital

(48:09):
would be lower.
And the same in reverse when we see that wecan't balance the budget or when Doge fails,
some people become more skeptical and then theten year goes up.
So it's not just this linear relationship thatpeople expect.
It's the US government itself is an actor inits own financing, for lack of a better term.

(48:29):
I think that's right.
The other way to think about it too, have youever heard the saying when you, if you, if you,
if you owe the bank a little bottle of money,the bank owns you.
If you owe the bank a lot of money, you own thebank.
You have to realize that a lot of foreign,countries, China, Japan, Europeans own a lot of
Us debt.
It's not in their interest to have US debtdefault either.

(48:51):
And so they don't want to see rates move upmeaningfully either.
It would throw a kilter the global economy, notjust The US economy.
We're incredibly linked.
Tariffs or no tariffs.
And so we actually have global interest largelyin alignment to find ways to operate
financially, even with The US running at a highdebt level.
So other countries that are holders, somepeople argue, the risk is China and Japan will

(49:14):
boycott our bonds.
It's actually not in their best economicinterest to do so.
And so the likelihood of foreign flowsmeaningfully flying out of The US debt market
is pretty low right now.
You mentioned crypto.
Is there a rational amount for high net worthpeople to have in their portfolio?
And how do you think about it?
Give me the framework in which to think aboutcrypto in a portfolio.

(49:36):
Crypto, just like any other asset class, is apersonal preference of an investor.
So it's no different than me saying to you, doyou wanna buy small cap stocks or do you wanna
buy real estate?
It can play a role for clients that believecrypto is a prudent piece of a well diversified
portfolio.
It's a harder asset class for some clients totake on because it's a relatively new asset

(49:59):
class.
And so we find a lot of clients choose not toinvest in it because it's just beyond their
level of comfort.
But for clients that feel that crypto is aviable asset class, no different than gold or
real estate or large cap stocks, then you wouldallocate some portion of the total portfolio to
crypto just as another means to hedge oneself.

(50:21):
If we think about what crypto's 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 ten years ago, here'sa piece of gold, a coin, and I want a thousand
dollar bills for that coin for each ounce.
Today, I want $3,000 bills for that gold coin,which is an ounce.

(50:44):
The gold coin never changed.
It's the same gold coin ten years ago.
It didn't really have much practical use.
What changed was the dollar fell in value, andI want three times as many of those dollar
bills for my gold coin.
If you believe in the thesis of cryptocryptocurrencies, and I'll pick on Bitcoin,
which in theory will have a limited issuance ofBitcoins between now and a hundred years from

(51:06):
now, the Bitcoin, just like a gold coin, is analpha alphanumeric code.
And today I'm not 118,000 of your dollar billsfor my Bitcoin.
I don't know what I'm gonna 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

(51:28):
for that same alphanumeric code.
But I think that concept is incrediblychallenging for many people to get their head
around.
And so again, it gets back to personalpreferences as to whether or not crypto should
be part of a well diversified asset allocation.
It's just yet another asset.
Well, Alan, this has been great to chat on RIAinvesting and everything.

(51:50):
How should people keep in contact witheverything that you're working on?
How should people follow you?
Well, you can, find all of us, at iQ Capital.
You can go to our website.
You're you're welcome to take a look and reachout to any of us, easily found.
You'll find that, we're publishing, somethought leadership on our website as well.

(52:11):
Some of us can be found on LinkedIn as well.
And we'd love to hear from, anyone who wouldlike to be working with a fiduciary, who
creates bespoke investment asset allocationsfor their unique investment.
Perfect.
Well, Alan, look forward to continuing thisconversation in person.
Thank you for taking the time.
Thank you.
It was a pleasure, David.
I really appreciate it.

(52:32):
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