The Exchanges

Q How did you go from the initial seven and change million learning these different asset classes to beginning to scale into what became an OCIO business?

A So we had to get twenty-five million dollars in year one, or something called U.S. Blue Sky Laws would have made our legal bills just astronomical. We hit twenty-five million at the end of the year just by adding the two asset classes, absolute return, and municipal bonds for the U.S. taxpayers. Then in year two, we'd hired people like Will Fox, who's still running North America with us today, and we said, we're not paying ourselves anything. If we don't get to a hundred million dollars, recognizing that breakeven was probably three hundred million dollars, If we didn't have the momentum, we weren't going to carry on, but in that second year, 2003, we actually got institutional clients. They were the institutions that knew about the Yale model, the endowment model, but they were a little bit rebels. They weren't the traditional people who were worried about what somebody else was going to think, and so they were going to hire the new guys on the block. Gonville and Keys College Cambridge hired us in that year. We hit the one hundred million dollar target with a mix of high net worth individuals, private equity GPs mainly, and smaller institutions, and then the next year, Will Fox and I said the same thing. We hired John Collis, who's just retired after 20 years, who ran Europe, and we started adding clients in the institutional market, mostly in Europe at that point. We hit fou…

AI assessment note: “So we had to get twenty-five million dollars in year one”

Q How do you balance the notion of static risk with the concept that there may be something like structured credit that you think is an opportunity?

A So we break our tactical asset allocation model into three layers. We call Layer one is just absolute risk. So we convert all those different betas and factors into one measure. We call it ENAB, equivalent net equity beta. It's equity-like risk. And we set the target, say, at 75 for a given endowment. And then when markets move it to 73, we rebalance up. Markets move to 77, we move it down. So we never time markets on level one. Level two, we have 13 asset classes or seven betas, whichever way you want to look at it. And we've got targets for each one of those, markets move those, or we have valuation views on level two, say, one of the 13 asset classes of emerging market equities, if we think that's gotten cheap, we'll do something there. That's also very difficult to do, so we don't do a lot of it. The third level is sub-asset class, tactical modes. So those are where our managers are giving us some insights, railways. That was one of our recent ones. We had, as an unsuccessful one, community banks going into 2023. Okay. Anyway, that's our level three tactical moves, and those tend to generate at least enough alpha to pay for our fees, if not a little more.

AI assessment note: “we break our tactical asset allocation model into three layers.”

Q Which two people have had the biggest impact on your professional life?

A Number one, it was my second family. I was very close to Dr. Tom Eliason in Fresno, California, where I grew up, and his wife, who was my den mother in Cub Scouts, and I spent so much time with them because their son was my best friend. Dr. Eliason was a leading cardiologist, and he was my role model. The impact he had on me was to be calm and thoughtful. My family Was full of drama. And so it must be the Portuguese DNA or whatever it is, but he gave me a sense of perspective and calm that compared to my siblings is distinctive. I think most of my work colleagues would say, really? I haven't noticed, but they have to understand what it could have been. And then secondly is a gentleman named Archie Norman. He's a serial CEO and chairman. He was the CEO of ASDA, Turnaround ASDA, Energis, ITV, and he's currently the chairman of Marks & Spencer, and I worked with him when he was at ASDA when I was a strategy consultant, and he has two unique characteristics as a leader, and one is that he just doesn't like doing anything ordinary, anything normal. He just strives to do things that surprise people out of the ordinary, and he taught me to always be Brutally honest and face into the unvarnished truth. I'm the chairman of the board of Partners Capital. You don't go into the board meeting to convince them that our investment performance is great. You find the area that's not great. You …

AI assessment note: “Number one... Dr. Tom Eliason... And then secondly is a gentleman named Archie Norman.”

Q There's probably nothing that's changed more in these 20 years than hedge funds and your next asset class you tackled way back when. How are you investing in hedge funds today?

A So first of all, we break them into two totally different groups. Hedged equities, anything with a beach of more than .2 to the equity markets. We call it an equity manager. And frankly, the learning is the same as in the long only equity space. But we do have more alpha from the hedge equity managers. They just tend to be deeper, more fundamental, and more specialists in a lot of cases. So our biotech managers are mostly equity long short. But in the absolute return space, first of all, more managers is better than few managers. There's a minimum where you debate whether it's 12 or 20, and you're all about Diversifying your sources of alpha. So what we learned is you can create, say, with 20 managers with the right mix of strategies and a very consistent source of alpha, call it three to four percent, not big numbers, with only three percent or even two percent alpha volatility, so information ratios of 1.2, and then what do you do with that information ratio? You leverage it. Ok, so that's how we invest in absolute return hedge funds. We create a very stable, solid stream of alpha, and then we leverage it.

AI assessment note: “We create a very stable, solid stream of alpha, and then we leverage it.”

Q So how did you take that initial high level idea and dive in and start to learn how you were going to go about implementing the strategy?

A One of the things I learned at Evolution Global Partners was to take things slow because we took it really fast there. The backers were Bonderman and Coulter of TPG, and Byers and Schlein of Kleiner Perkins, and then there was a Bain investment with John Donahoe, and they were just pushing us so hard. We hired 35 expensive people overnight, built these two offices that never spoke together. It was not a good way to build a business, so I took it really slow. We started with three employees, with one in Boston and two in London. We just chose the very next Asset class, and it was right on the back of the tech bubble. Nobody wanted any more equity exposure. So what did the doctor order? Absolute return hedge funds. We just started studying the hedge fund space. It was very much the market neutral end, so equity market neutral strategies, merger arb, fixed income arb. And we just found, and we got access to, just through relationships, things like Tudor and Caxton. And so we were off to the races. We just went to the next asset class, and the next asset class, and the next asset class, pulled out a blank sheet of paper, reminded ourselves what the Swenson book said, but really pulled out a blank sheet of paper and said, how do we invest in municipal bonds? What's the right way? Should it be high yield? You know, what duration? You know, just every single aspect of every asset clas…

AI assessment note: “pulled out a blank sheet of paper and said, how do we invest”

Q What else have you done in the more modern version of what you've applied to the original endowment model?

A I mentioned two, so the risk management and then the tactical asset allocation. The third one is just focus on being a value added LP is very intense. We have actually a best demonstrated practices book. It's about 70 pages on post acquisition operating value added that we share with private equity managers. So that's a very meaningful part of it. On top of that, I'd say this focus on beta as a risk measure, not volatility, is very important. A lot of people out there in our business think about the average endowment portfolio should have 10% standard deviation around its annual returns, 10% volatility budget, which makes no sense, because what happens when markets go down, volatility goes up, all of a sudden your portfolio is over risked, what do you do? To de-risk it, you sell right after the market got cheap. So you're selling into lower prices. And the opposite, when markets go up, vol goes down, and you're buying at expensive prices. So that's another aspect of it. There's some main changes.

AI assessment note: “The third one is just focus on being a value added LP is very intense.”

Q think about that area, the 12 to 20 managers, as you define a manager, can mean a lot of different things, because so much of the assets have gone into these platform hedge funds that are effectively doing that aggregation diversification for you. So how have you balanced the ability to put capital in some of those strategies with, say, a Millennium or a Citadel, an individual single strategy manager?

A We probably should have allocated to the Citadels and Millenniums. Ok, we should have. We, Just always look at the fees. We have an acronym for everything, as you've highlighted. EROC is our excess returns on costs. The EROC is terrible. And another way to think about it is, of the total gross alpha, how much do they keep? It's about 80%. We get 20% of the alpha. The alpha's huge. Absolutely huge. But we could never get comfortable with only getting 20%. So what do we do? We allocate it to their spinoffs. And it's mostly Citadel spinoffs. They've done very well, and they're closer to two and 20, and we get roughly 50% of the gross alpha, and we diversify. They'll be specialists in consumer or specialists in tech, and we have to create a diversified portfolio of those.

AI assessment note: “So what do we do? We allocate it to their spinoffs.”

Q As the years have gone on, 20 years plus since David wrote Pioneering Portfolio Management, how have you evolved how you've thought about the endowment model?

A So, number one is risk. You think about the result of an endowment model, you end up with, pick a number, 6200 managers, ok? And you think you understand from their exposure reports what you own, but you don't know what you own just from their exposure reports. So you have to go really deep in knowing what you own. We understand the underlying stocks that most of the portfolios have. We get all that data, and then we run it through our factor models to know where we've got over and underweights. Because one manager may be doing the same thing as four other managers, and all of a sudden, we've got tons of exposure to clinical trials risk, okay? That's the single biggest change in the endowment model is the risk management, and that's what risk management means to us. We show our clients what we call the risk dashboard. Which has over 16 different metrics, including the value and quality and momentum factors, as well as liquidity factors, currency. You have to understand all of this, because odds are, when you got an overweight that was unintentional, it goes against you. And when it goes for you, you call it alpha, and you don't pay attention to it, but you should. You should pay huge attention to any source of alpha. It's probably beta.

AI assessment note: “That's the single biggest change in the endowment model is the risk management”

Q Why don't you take me back to the founding of Partners?

A Okay, this is right after the tech bubble burst. I'm sitting in my kitchen, as the story goes, with my next door neighbor, Paul Dimitrik. We have both been private equity investors. Paul started Investcorp in Europe, and I was working for Evolution Global Partners, which was a Kleiner Perkins spin out. As the tech bubble burst, our Balance sheets reflected that, because we were very concentrated in, guess what, private equity, the asset class that could never go down, just went down a lot, especially if we had tech-oriented investments. So in our minds, we were embracing diversification as a solution to that problem, and in the weeks prior to that, we had been meeting with various private banks, mostly the Goldman Sachs, Citibank, UBS of this world, and it was, Just shocking what we learned. I mean, number one were just the conflicts. The number of Goldman products or Citibank products, it was just astounding. And if they did have third party managers, there were generally no benchmarks. And if you did find a benchmark, it was the wrong benchmark. So you had not only conflict of interest issues, but transparency issues. We couldn't get to the costs in many cases of the assets. When we went through the manager's performance, we realized that most of the, the managers had no alpha, so why would we ever hire a private bank? And we thought about where we find the solution, and it j…

AI assessment note: “I'm sitting in my kitchen, as the story goes, with my next door neighbor”

Q When you initially sought out to say, we're going to replicate or triangulate on the Yale model, what did that mean to you and what you were delivering for your clients?

A After 19 years at Bain, you just had an appreciation for the fact that there was a best way of doing almost anything. I'm an academic purist, and our mission is to take the most advanced, proven institutional investment approach to our clients. The endowment model in our definition, and May not be your definition, may not even be David Swenson's definition, but it had three pillars. Number one, high static risk. So static means no market timing, and that was definitely a David Swenson platform, but also the high meant it's long-term money. You can take the volatility. Secondly, multi-asset class diversification with a bias towards illiquid assets, but not necessarily defining them as illiquid, but just you can take higher risk, you can take the illiquidity, Let's go for it. So that was certainly the second pillar, and something we definitely copied of the Yale model was that you don't give money to the big retail, publicly listed asset managers that are in the business of turning out 40 new funds every year. You went with the concentrated specialist, entrepreneurial, owner-operated asset managers who had the bulk of their balance sheet in their own funds, so the skin was in the game. And so those were the three platforms that we followed, and that was enough work. Really, the focus in the early years was just being a deep expert on every asset class. We always had a benchmark t…

AI assessment note: “The endowment model in our definition... had three pillars.”

Q Have you thought about internal capabilities compared to giving money to external managers?

A Well, we started life, no conflicts here, so there's a high bar on that, but we do have such strong relationships with liquid and illiquid managers, so we do a lot of co-investing, private equity, private debt, and property, and the liquid, illiquid asset classes, we've always done co-investing, and it's been very successful. Our targets today are about 20% in there, but about seven years ago, we started co-investing in public equities, so with our long-hold Closest manager relationships. We just talked to them about those positions and said, do you care if we double up on them? We're not going to pay you any fees. And most of them said, no, you're a big investor, probably be helpful. So that's the closest we've come to direct investing. The rule is that if we can't find it externally, we're allowed to do it internally. So we launched something on the back of COVID called the New World Equity Portfolio. The New World Post-COVID Was one that was embracing technology, working from home, and you can imagine the sorts of things we invested in. They were both overcorrected companies like retail and airlines. We owned those, and we owned the beneficiaries like Zoom. And so that was one that we just couldn't find anyone else doing. We did it. It worked. The logical lifespan came to an end, and we stopped it. Right now, we're looking at one in the energy transition space. It's all abou…

AI assessment note: “The rule is that if we can't find it externally, we're allowed to do it internally.”

Q So if you've grown your asset base and grown your allocations to these managers, how have you tackled the sweet spot of this middle market?

A So we're now in the fund number two and number three space. That's our sweet spot. We have great relationships with certain names, and we get big allocations with them, and they've gone up to five or six billion dollar funds, but it's still working. We can call that middle market these days, but the best solution is just know the middle market firms that are most likely to create spinoffs and watch, and we have our relationships with the search firms and others, so we get usually early heads up On firms that are leaving. We'll typically meet the management team the first time. We pass in most cases, not in all cases. We've done some fund ones, but generally we say, we're going to watch you. Please hold some space for us for fund two, and we're in fund two.

AI assessment note: “So we're now in the fund number two and number three space. That's our sweet spot.”

Q How have you thought about in the public markets? You said in the old days you thought maybe Mr. Vanguard was the right solution. Then it was such an important part of your portfolio. You started looking for active managers. And now it's just increasingly hard with all these other factors to prove that you're adding value. What have you done about that?

A There's a portfolio construction solution. Turns out information ratio is probably the most important metric in liquid securities or asset classes, ok? So how much alpha do you expect is the numerator? How much volatility, single standard deviation around that alpha do you expect in any one year? And if you think about that all the time and you're adding managers, theoretically what you do is you start with the highest information ratio manager, allocate as much as you think you can Based on that volatility, maybe it's six percent of your total portfolio is a large allocation for us, and then you add the next highest information ratio, and then you look at what you own underneath that, and you find, oh, we've got a lot of growth in there, and you have to rebalance it. So that's the basic portfolio construction model for liquid securities. Credit's a little bit different because there's a lot of tactical asset allocation in there, so we're always taking a view on the different sub-asset classes of credit.

AI assessment note: “There's a portfolio construction solution. Turns out information ratio is probably the most important metric”

Q What are some of those mistakes that you made that you've tried to transfer onto the team?

A Commodities is a great one. Okay. As we say today, it's a graveyard of failed investment decisions, because almost every strategy that we were looking at had commodities in there. And they're active commodities, not passive commodities, because you learn about commodities, there's no yield, there's no income. So over time, they actually go down because of economies of scale. It turns out in commodities, to know enough about what you're investing in, you have to specialize. So you just do energy commodities, and you are whipsawed all over the place. So it's up 80, down 60, you have to own four or five of them, but they go out of business after three years. That was a big learning, so we don't do commodities today. That's a whole asset class learning, and there's more Specific learning about individual managers and every asset.

AI assessment note: “Commodities is a great one. Okay. As we say today, it's a graveyard”

Q Where do you think Partners goes from here?

A I do think we end up doing some more direct investing. We see a thousand managers a year in any one asset class. We just know so much about each asset manager. Most of us just sit there and perspire over all the opportunities we're seeing that aren't being exploited. So when I said the rule is we can only exploit those opportunities that haven't already been exploited by amazing people outside Partners Capital, there are a lot. And so I think we're going to cross that boundary at some time very delicately. We don't want to break the rule that created us, no conflicts, but I think there's some opportunities our clients should benefit from where they could see much lower fees and a lot more alpha if we integrate forward into asset management.

AI assessment note: “I do think we end up doing some more direct investing.”

Q Every client has their own reason for being, their own set of values, their own goals. How did you scale trying to do this for lots and lots of clients?

A First of all, you're right that almost all our clients want something highly customized, and the primary reason that would make sense is that they had a very different risk profile, or they had particular biases against their current balance sheet of property and private equity, and so they'd have a different allocation. But in the end, the private equity GPs ended up doing something that looked a lot like the endowment model, and of course, the institutions did. Even the customization is generally about asset allocation, not about which asset classes are included. Almost all asset classes are included in almost all client portfolios, even the private equity GPs today. So the customization came down to really sizing of managers or simple allocation decisions, whether it's eight percent private debt versus 10% private debt.

AI assessment note: “customization came down to really sizing of managers or simple allocation decisions”