The US commercial real estate market is a massive $7 trillion asset class, with $2 trillion accessible through liquid securities like CMBS and REITs, creating a niche that is big enough to offer opportunities but small enough to avoid overcrowding by specialists.
Jim Higgins contextualizes the US commercial real estate market at $7 trillion total, with $2 trillion in liquid securities, creating a niche that is large enough for opportunity but small enough to avoid overcrowding by specialists. ✦ AI generated
Jim Higgins · Invest Like the Best · 2017-12-19 · original ↗
plays this moment only · 4:00 — 5:30
“So for my own edification, I thought the best place to begin would be for you both to outline this world, broadly speaking. What does it look like, what kind of assets are there, how can you access them, and then we'll use that as a jump-off point.”
When you look at the numbers, the US commercial real estate market cap, if you will, is around 7 trillion. So to put that in perspective, the single family home market is around 22 trillion. Obviously the housing market's gonna be bigger, but 7 trillion is obviously a massive asset class. The New York Stock Exchange alone, also just put it in perspective, is around 19 trillion was the last number I saw.
verbatim transcript · starts at 4:00
(00:00:00) I know firsthand how complex the tech stack is for asset management firms. (00:00:05) And seemingly, every new tool and data source makes the problem even worse, adding more complexity, more headcount, and more risk. (00:00:11) Ridgeline offers a better way forward, one unified platform that automates away the complexity across portfolio accounting, reconciliation, reporting, trading, compliance, and more, all at scale. (00:00:21) Ridgeline is revolutionizing investment management, helping ambitious firms scale faster, operate smarter, and stay ahead of the curve. (00:00:28) See what Ridgeline can unlock for your firm. (00:00:30) Schedule a demo at ridgeline.ai. (00:00:33) This podcast is sponsored by CFA Institute, the Global Association of Investment Professionals whose mission is to lead the investment profession by promoting the highest standards of (00:00:41) ethics, education, and professional excellence for the ultimate benefit of society. (00:00:46) CFA Institute serves a global community of investment professionals working to build an investment industry where investors' interests come first, financial markets function at their best, and economies grow. (00:00:56) The Chartered Financial Analyst Credential is the most respected and recognized investment management designation in the world. (00:01:03) The views expressed in this podcast do not necessarily represent the views of CFA Institute. (00:01:11) Hello and welcome, everyone. (00:01:13) I'm Patrick O'Shaughnessy, and this is Invest Like the Best. (00:01:16) This show is an open-ended exploration of markets, ideas, methods, stories, and of strategies that will help you better invest both your time and your money. (00:01:24) You can learn more and stay up to date at investorfieldguide.com. (00:01:32) Patrick O'Shaughnessy is a principal and portfolio manager at O'Shaughnessy Asset Management. (00:01:36) All opinions expressed by Patrick and podcast guests are solely their own opinions and do not reflect the opinion of O'Shaughnessy Asset Management. (00:01:43) This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. (00:01:48) Clients of O'Shaughnessy Asset Management may maintain positions in the securities discussed in this podcast. (00:01:54) So far, I've spent no time in this podcast discussing real estate, so I was excited to get the chance to talk to the team at Soren Capital, a billion-dollar hedge fund which specializes in commercial real estate, REITs, and commercial mortgage-backed securities. (00:02:07) Soren is led by Jim Higgins, who founded the firm, and Tom Deegan, who coincidentally was a college classmate of mine at Notre Dame. (00:02:13) This conversation has two angles. (00:02:15) The first, which starts about 20 minutes into our talk after we introduce the sector and the opportunity set, is a deep dive into a specific trade, a fairly contrarian take on the retail industry, specifically comparing different types of retail real estate. (00:02:29) As you'll hear, the dispersion of mispricings in the sector may be huge, creating opportunities for specialists to earn real alpha by doing bottom-up work. (00:02:38) The second angle we explore is what I believe to be a strong model for the future of asset management businesses. (00:02:44) That is, tailoring products, strategies, and even specific trades to the needs and risk-return profiles that clients want and need, instead of just selling a one-size-fits-all commingled fund. (00:02:55) You probably heard me joke that this podcast should be called This Is Who You're Up Against, and this episode is a good example of why. (00:03:01) I always enjoy exploring a niche part of the market, and this conversation on real estate is a perfect example of the type of work that firms do on behalf of their clients. (00:03:09) Please enjoy my conversation with the team from Soren Capital. (00:03:16) All right, Tom and Jim, this is going to be the first time that I've spent any time on the podcast exploring real estate specifically. (00:03:22) We've done a decent amount of quant research into just REITs, which I know is just one component of the real estate world. (00:03:29) So for my own edification, I thought the best place to begin would be for you both to outline this world, broadly speaking. (00:03:36) It's a nice one because the underlying assets here are something very tangible that everyone can appreciate, office buildings, residences, real estate of all kinds, but it would be great to get a sort of summary of the topography of the space. (00:03:50) What does it look like, what kind of assets are there, how can you access them, and then we'll use that as a jump-off point. (00:03:55) Yeah, I think that's a good place to start. (00:03:57) I mean, I think, (00:03:58) Just to start off, I mean, it's a big space. (00:04:01) It's a big space for sure. (00:04:02) When you look at the numbers, the US commercial real estate market cap, if you will, is around 7 trillion. (00:04:08) So to put that in perspective, the single family home market is around 22 trillion. (00:04:13) Obviously the housing market's gonna be bigger, but 7 trillion is obviously a massive asset class. (00:04:19) The New York Stock Exchange alone, also just put it in perspective, is around 19 trillion was the last number I saw. (00:04:24) So it's a big sector, but I think that while people can really, (00:04:28) appreciate commercial real estate in that it's at the center of most every economy. (00:04:33) It's not something that they always feel is accessible in the way of actually trying to access some of those returns, as you put it. (00:04:39) So just to kind of break that down and talk about how that $7 trillion has really broken out, or more importantly, I guess, how you would get access to some of those returns, there's really four ways. (00:04:48) One would be going out and buying a building. (00:04:50) The other would be originating or participating in some way, lending on a commercial real estate asset. (00:04:56) And then the two, (00:04:58) liquid ways to access it. (00:05:00) The liquid commercial real estate that we really focus on would be the commercial mortgage-backed securities market, also called CMBS, and then the REIT market. (00:05:08) The REIT market is broken up in two. (00:05:10) The actual property REITs are the bigger of the two groups. (00:05:13) The second group would be the mortgage REITs. (00:05:15) The property REITs actually own and operate buildings, whereas the mortgage REITs are either investing in commercial mortgage loans or financing them in some capacity. (00:05:25) So we focus more on the property REITs themselves. (00:05:29) Just to break that out even further, so on 7 trillion of commercial real estate market cap, there's 4 trillion of mortgage debt. (00:05:38) And that's by looking at the Fed data as of the end of last year. (00:05:41) The CMBS component, which is what we look at, which is at the liquid end is a trillion. (00:05:46) So it's around 25% market share of the mortgage debt. (00:05:50) And then in looking at REITs, you have 1 trillion of REITs as well. (00:05:54) So you're talking about (00:05:55) of the $7 trillion market cap of commercial real estate, $2 trillion are what we consider to be the liquid ends that we focus on in the security side. (00:06:04) I think I'd just add there, for us, we're a specialist manager, right? (00:06:08) So we are liquid commercial real estate securities and commercial real estate loan investors, which is very specialized and it's a niche. (00:06:16) But at a trillion market cap for CMBS, a trillion market cap for REITs, (00:06:22) They're big enough where there's quite a bit to do, and they're interesting, but they're small enough where not everybody is participating in it, and there's not that many kind of true specialists and experts in it. (00:06:34) So it's kind of a nice combination of big enough, but not too big, and a lot of inefficiencies for a manager like us to take advantage of. (00:06:43) The next question that that begs is sort of the profile of the investors in the space relative to the profile of investors in, let's say, like the broad equity markets or debt markets. (00:06:53) So is there a different profile of people that tend to own, I guess, real estate more broadly speaking, whether it's institutional investors, individual investors with different motivations, versus a more traditional (00:07:04) investor sets, like who are the owners? (00:07:06) Commercial real estate is an asset class. (00:07:09) Pretty much every institutional investor out there probably has an allocation to commercial real estate just because it's such a major asset class. (00:07:16) So you've got pretty much any major institution, they've got private equity, they have alternatives, they have commercial real estate, and then they have your traditional fixed income and traditional equities. (00:07:25) So most every institutional investor is exposed to commercial real estate and has a regular allocation. (00:07:33) When you start getting into the liquid end of commercial real estate, CMBS and REITs, that drops off a lot. (00:07:39) So one of the interesting things is, as we talked to some of these institutional investors, is when you go to the commercial real estate group, they hear CMBS, REITs, liquid securities, and they point you down the hall to either the equities or the fixed income guys. (00:07:56) And then when they hear it's commercial real estate related, sometimes they point you back down the hall to the real estate guy. (00:08:03) And then if it's a long-short strategy, they'll point you to the hedge fund guy, which then points you back to the real estate guy. (00:08:09) So it's a unique combination of characteristics that they have where it's part security and it's part commercial real estate. (00:08:19) And again, so that kind of sometimes makes it fall through the cracks for some investors, which again goes back to creating opportunities. (00:08:26) It's not an overcrowded space with people that are really looking to do deep dive credit work. (00:08:33) The investor base for CMBS and REITs, it's evolved over the years. (00:08:37) I mean, for CMBS, (00:08:39) I mean, the sector has really only been around since early to mid-1990s. (00:08:45) And so 15 years ago, primarily, it was insurance companies that were the primary investors in CMBS. (00:08:52) 10 years ago, heading into the financial crisis of '07, '08, you had a ton of structured finance vehicles, CLOs, CDOs, SIVs, and hedge funds pretty much across the board that were investing in CMBS, regardless of whether they were specialists or not. (00:09:09) The financial crisis kind of changed all that, right? (00:09:12) I mean, you're not really seeing SIVs and CDOs, and you're not seeing as many non-specialist hedge funds playing in it. (00:09:20) Currently, you've got a lot of big money managers, so kind of your traditional asset managers that have allocations across all aspects of fixed income, mutual funds. (00:09:29) Hedge funds are still playing. (00:09:30) You do have non-specialist hedge funds that are still playing. (00:09:34) But the most common characteristic is (00:09:36) In CMBS, the investor base, it's dominated by beta investors and investors really just looking to get sector exposure. (00:09:44) REITs, kind of similar in how it's evolved. (00:09:47) Going back even further, REITs have been around a little bit longer. (00:09:51) 20 years ago, it was primarily retail, individual investors, probably over 85% of the market. (00:09:56) 15 years ago, you started getting more dedicated retail mutual funds, a lot of Asian investors and Asian mutual funds, particularly Japan. (00:10:05) And now you're seeing some hedge funds, some generalist hedge funds playing in it, along with retail, dedicated mutual funds. (00:10:13) So, you know, kind of a broad base. (00:10:16) One of the key things always is motivation for investing in this, if you're going to carve out an asset class as something separate that's not, say, lumped in with an equity exposure or just a broad fixed income exposure, is that you're expecting some unique characteristic, whether that be low correlation, a higher average yield, more tangible underlying asset, asset-intensive type businesses. (00:10:36) So maybe highlight for each of those, or for the two main categories being, I guess, individual investors and more institutional investors, what are the structural attractive characteristics of a real estate portfolio, a liquid real estate portfolio specifically? (00:10:50) I think when it comes to real estate, the reason it's so attractive is that it's dynamic. (00:10:56) Properties can be both offensive and defensive. (00:10:59) It can grow like equity, but it also can provide as much security as a bond. (00:11:03) I think that there's a lot of data that'll show they can also serve as some form of inflation protection. (00:11:08) We've seen different data on the core, a lot of people say there's a low correlation to other asset classes, but we know that correlations tend to increase in times of stress, so that's not always a place to hide there. (00:11:19) But on top of that, in this environment, where a zero interest rate environment we've been living in for a while, there's significant yield in the space, and I think that's very attractive. (00:11:28) Let's talk about your own evidence. (00:11:29) given that you guys have been operating in this space for a long time. (00:11:33) I think that like any niche where your story about people pointing you to other parts of the hall resonates. (00:11:40) If I was an investor in this niche, that makes me happy, that there's not like some dedicated resource looking just at managers that kind of doesn't fit one particular bucket. (00:11:48) But maybe talk about Soarin the business, how it began, maybe your background, Jim, before Soarin, as a precursor to us getting into structural inefficiencies here because (00:11:58) Of the conversations I've had on the podcast, some of the most interesting ones have been these kind of more esoteric niche parts of the market, where perhaps there are more inefficiencies that are more lasting than, say, the S&P 500. (00:12:10) So some background, I think, would be- Yeah, sure. (00:12:12) So I mean, my entire career has been commercial real estate related. (00:12:16) And so that goes back to the late 80s, which makes me feel pretty old. (00:12:20) Started my career at a commercial bank in Chicago as a construction lender right out of the credit analyst training program. (00:12:28) And being a construction lender in the late 80s, early 90s was pretty much of an oxymoron because that was probably one of the worst commercial real estate markets coming out of the S&L crisis. (00:12:38) Banks were having major struggles, some banks went under, and the main reason was their commercial real estate loan portfolios. (00:12:46) And out of that crisis, the RTC started using the securitization model to try to get rid of some of the loans and to help out some of these bank balance sheets. (00:12:55) And so that whole securitization business model that had already been applied to residential mortgages started to be applied to commercial mortgages, and that intersection of kind of capital markets and commercial real estate really, it made sense to me. (00:13:08) Can you expand on that notion a little bit? (00:13:10) So most people, when they hear securitization of real estate, are going to think about one thing, which is residential securitization that kind of blew up the economy in 2008 and 2009. (00:13:21) Yeah, I mean, commercial mortgage- Talk about why it's appealing. (00:13:23) Yeah, commercial mortgage-backed (00:13:25) charities, much simpler from a structural standpoint, much more vanilla than the residential world. (00:13:32) Usually when people have kind of bad visions in their head about mortgage derivatives, it's usually the residential world that had some pretty esoteric, funky structures that created some very unique, some high-risk profiles. (00:13:47) CMBS is pretty basic, pretty vanilla. (00:13:49) There's not a lot of structural complexity in it. (00:13:52) Can you describe the basics of how? (00:13:53) Yeah, so securitization, really what it does is it takes a particular asset, in this case, it's commercial mortgage loans that used to be really just held by insurance companies, banks, and pension funds, and it expands the investor base by taking those loans and creating different profiles of securities with those loans as raw materials. (00:14:15) So rather than having just one 10-year commercial mortgage loan, (00:14:20) with a 6% coupon on it, you can take a bunch of those loans and create a three-year bond that's much more senior than anything else in the structure and have a much lower rate on it, create a much more subordinate bond that's a much longer 10 or 12-year bond with a much higher interest rate and a range of bonds and profiles in between. (00:14:42) The motivation for which being investors have different priorities, want different duration, want different yields. (00:14:48) So it's basically a way of taking one (00:14:50) consistent underlying thing or pool of things and providing a bigger menu. (00:14:53) Yeah, the ultimate motivation is to bring more capital into a sector by expanding the access to more investors and to create different profiles so there's more investors with different profiles that can participate in it. (00:15:07) I think, again, people have been attracted to it because they understand commercial real estate, and while security's a little different, they still understand that the underlying fundamental analysis is commercial real estate. (00:15:19) We're also seeing that more institutions are starting to consider the liquid real estate investments in their more traditional commercial real estate bucket. (00:15:29) As in a swap out, meaning they'll sell hard assets in favor of what-- Less of a swap up, but more if they say, look, 10% of our overall portfolio is allocated to commercial real estate, that they might take 10% of that 10% and say, we're going to have that portion be in liquid commercial real estate related assets. (00:15:47) I think especially coming out of the crisis, they see that while commercial real estate is attractive in a lot of ways, it's also very illiquid. (00:15:55) And when you're in an illiquid asset, you're short opportunity options. (00:16:00) And so for those that had cash or liquid investments that when the storm clouds started gathering in 2007, when some people started to get to cash, they were then in a position to take advantage of some fantastic investment opportunities and laid a wait in 2009. (00:16:17) And so one thing we've talked to some of our clients about in their real estate, commercial real estate allocations is have a small portion in something that's liquid so that you're long opportunity options. (00:16:27) I mean, we're, what, eight years now into a pretty historic asset inflation cycle, driven in large part by historically low interest rates and a lot of involvement in the markets by central banks around the globe. (00:16:42) I think there's a lot of investors out there that are (00:16:45) a bit nervous and have a hard time finding a lot of deep value out there. (00:16:48) And while I don't think anybody's comfortable saying, oh, there's a big down trade in the market coming anytime immediately soon or predicting when that's going to happen, I think we are finding more and more investors wanting to be cautious and having some ability to be tactical when and if there is a downdraft of the market. (00:17:07) So having that liquid component in a commercial real estate (00:17:12) portfolio, I think, is starting to gain a little bit more traction amongst institutional investors. (00:17:18) It kind of reminds me of the research papers showing that levered small-cap equities, public small-cap equities, or mid-cap value equities could replace your private equity allocation, and that there's no real reason that the illiquidity premium maybe isn't what it once was, and that you're seeing something similar in REITs today. (00:17:34) So you were in the midst of it in sort of the creation phase of the CMBS sector in the 90s, and then you moved, I believe, to Bear (00:17:42) So talk a bit about Bayer and then the transition to, I guess, the motivation for founding your own business that's doing something very specific in the space. (00:17:51) Sure, so I joined Bayer in March of '97, actually I think it was St. (00:17:55) Patrick's Day, I remember, March 17th, 1997. (00:18:00) And that was still in the infancy stages of the CMBS market. (00:18:02) It was developing, it was evolving, and the market went from being 40 to 50 billion of annual CMBS issuance to almost 200 billion by 2007. (00:18:13) So I left Bayer at the end of '03 at a point in time where it felt like things were getting pretty aggressive in terms of CDOs, CLOs, SIVs, and little did I know that that was just at the very beginning stages 'cause it got much more aggressive heading into '06 and '07. (00:18:29) But what I saw was in commercial real estate investing, there was only one option, which was to be long and to be exposed to the market. (00:18:37) And there really wasn't any relative value or long-short options. (00:18:41) So I felt there was an opportunity for a well-conceived long-short strategy, and that was the impetus for starting Soren. (00:18:48) And we got pretty good interest early on, where there's a lot of investors. (00:18:52) and the alternative space that are looking for something different, where they're looking for a different risk factor, a different return driver. (00:18:58) And so a long-short strategy in commercial real estate securities was unique. (00:19:02) There just really wasn't anything out there like that. (00:19:05) So when we launched, we were really the traditional hedge fund. (00:19:08) Here's our fund, let's try to get 50 to 100 LPs all in one fund and do what we do. (00:19:14) And it worked fine in the bull market, but what we found heading into the crisis was (00:19:21) Every LP has different views, different philosophies, different tolerances, different goals. (00:19:28) And so having just one fund with 100 LPs in it, particularly in something as unique as structured products and CMBS and REITs, that there was a lot of risk of value transfer with investors wanting to come in and out, especially during challenging markets. (00:19:44) And then also everybody wanted something a little bit different. (00:19:46) So coming out of the crisis, our firm evolved. (00:19:51) It's where rather than the goal being let's have 100 LPs in one fund, we'd rather have a few dozen LPs in a range of portfolios that are customized towards individual LPs or groups of LPs that have kind of similar profiles and similar tolerances. (00:20:08) So it really kind of goes to the one size does not fit all. (00:20:11) And I think it really lends itself well, particularly to a niche sector like ours, where there's lots of different profiles that we can create. (00:20:19) We have one very large institutional investor. (00:20:21) It's probably one of the largest allocators to alternatives in the world. (00:20:26) We're doing four different things for them. (00:20:28) And the profiles are very different. (00:20:30) Fee structures are different. (00:20:32) The risk parameters are different. (00:20:34) And so that's really the way that our business has evolved to where we're trying to be much more customized, much more of a bespoke provider, and being more than just a here's our product. (00:20:45) And we're saying, (00:20:46) We're really good at this space. (00:20:48) Let's talk about what's interesting and what it is we can do for you and what it is your goals and your needs are. (00:20:53) So we'll use this as an opportunity to talk in depth about a very specific trade, in this case, retail. (00:20:58) And we're going to come at retail from kind of all different angles, from the credit angle, from the equity angle, and from the kind of macro viewpoint that you have as an opportunity here in a discrete period of time. (00:21:09) So Tom, maybe you could start by at a high level outlining the situation that we're in. (00:21:13) This is going to be popular because retail is a popular (00:21:17) topic today in markets, in large part because of one stock, Amazon. (00:21:21) So maybe just give your general impression and then we'll go into a trade like this so that everyone can get an idea of how specific something like this comes together inside of a hedge fund. (00:21:29) Sure, now retail is certainly a great example of the typical kind of thematic dislocation that you'll see in commercial real estate securities. (00:21:37) So just by way of background, take a step back for your listeners. (00:21:41) As many of them will know, the retail industry and frankly, anything with perceived exposure to the retail industry have recently come under fire. (00:21:48) In the second quarter of this year, retail became the highest yielding sector in high yield, officially overtaking energy. (00:21:55) We stopped keeping track at least in the last two months, but as of a couple months ago, we already had over 1,500 store closures. (00:22:01) That number is definitely over 2,000, and that's really just looking at... (00:22:04) more of the national chains, and you have an even larger pipeline looming. (00:22:08) We've had more than 10 major national retailers file for bankruptcy in 2017 alone, countless more companies on watch. (00:22:15) I saw a stat that if you include some of the smaller, more local players, the number is upwards of 300, which to put in perspective is more than what we saw bankruptcy-wise in 2003 to 2006 period in total. (00:22:28) And that's in the span of half a year, so it's pretty impressive. (00:22:31) So on top of that, over the last nine months, many retail-related property REITs have declined in excess of 30%. (00:22:36) Select CMBX tranches with higher than average exposure to retail are down 10 to 15 or more percent as well. (00:22:43) One vocal market participant has gone so far as to label CMBX the next big short, based largely on a negative retail industry thesis. (00:22:52) The impending death of malls has been a popular media storyline that is constantly in the headlines. (00:22:58) Frankly, every institutional investor we speak with is asking about retail, tell me about malls, tell me about CMBX. (00:23:04) Thus, we have diverted a ton of resources to dig even deeper on this subject. (00:23:08) So what's our take? (00:23:08) Our take is that this isn't new. (00:23:11) Retail has always been the sector that we were most concerned about and the sector that we spent the most time on relative to other sectors, especially being credit investors. (00:23:19) The retail industry, frankly, it's constantly evolving. (00:23:22) Some tenants are failing, some are thriving, and new ones are coming on the scene. (00:23:25) That's been the case since the beginning. (00:23:28) Just by way of example, JP Morgan had a great slide in a research piece a couple months back, and it depicted Simon Property Group's top 10 tenant roster since their IPO in 1993, and what you'd see is that that tenant roster has turned over more than three times since their IPO in '93. (00:23:45) So I think that just puts in perspective that retail industry is frankly always changing, retailers are coming and other retailers are going over time, I mean frankly Sears, Macy's, JC Penney, (00:23:56) And even some of the smaller struggling apparel retailers seem to attract most of the headlines. (00:24:00) But many other retailers appear to be growing and thriving. (00:24:03) Some examples that we all know, Warby Parker, Apple, Apple, Bonobos, Athleta, Anthropologie, the list goes on. (00:24:11) So the point is, it's definitely a story of winners and losers. (00:24:14) Many on the ground creep professionals that we speak with reject or at least question the death of shopping centers and malls narrative. (00:24:21) While the prospect of online retail sales making physical stores obsolete is certainly a good conversation piece, consider that the absolute dollar of traditional retail sales is actually higher today than it was in 2007, and e-commerce sales still represents only 8.3% of those total sales numbers as of the end of last year. (00:24:41) So we agree that the U.S. (00:24:43) is over retailed, we're not arguing that, but I think we would make the case that it's a lot more nuanced than that. (00:24:48) The headline number that everyone likes to reference is 23 square feet per capita of retail square footage in the United States. (00:24:56) When you compare that to other developed countries at five square feet per capita, there's certainly a big difference. (00:25:01) About five being like the international average. (00:25:03) Exactly, looking at other developed countries, so there's a huge difference, but you need to unpack that a little bit and actually look at the composition of (00:25:11) retail here. (00:25:12) And what you'll find is that more than half of that square footage is made-up of malls, department stores, and other large anchor tenants. (00:25:18) Thus, when you break it down, it's really just that the US is over-malled and frankly over-appareled, and this is not new to anyone that's been following the space. (00:25:26) And so while malls will continue to close, not every mall is a bad mall, and I think even more importantly, not all retail real estate is a mall. (00:25:35) We believe this is a healthy, natural, evolutionary process, and it doesn't mean that all malls are bad or high-risk necessarily. (00:25:41) It's an important point that this is one big trend. (00:25:45) And one of the key things we've seen in markets is bundling of securities, REITs and REIT ETFs, ETFs as bundles of other kind of themes or industries or whatever. (00:25:55) And that often the behavior that that can create is a high level narrative sort of washing out maybe competitors within the space that don't deserve to be, which obviously could create an inefficiency or an opportunity. (00:26:07) So maybe let's dive again deeper into the (00:26:11) composition of an example of a trade. (00:26:14) So an example of where markets are, Macy's is doing terrible, Kohl's is doing terrible, kind of the big headline names, yeah, they're doing badly shutting stores, but you mentioned some are thriving. (00:26:24) So from an investing standpoint, how do you actually take advantage of that? (00:26:28) What's the positioning of the portfolio that allows you to take advantage? (00:26:31) Sure, I think I'll let Rick take this one, but real quick, just to preface it, as I mentioned, we did a lot of work. (00:26:36) And (00:26:37) Frankly, Rick will tell you shortly that the price movement that we've seen in some of the regional malls makes complete rational sense. (00:26:44) The move we've seen in certain CMBX and CMBS cash bonds makes sense as well. (00:26:49) But one area of the market that doesn't make sense and we think represents a massive buying opportunity is that select shopping center REITs are actually extremely attractive and it's a classic baby thrown out with the bathwater, where if you look at the chart between select shopping center REITs that Rick has identified relative to a mall REIT, it's really hard to tell the difference. (00:27:07) And I think what we'll get into is the difference between those businesses is really important. (00:27:12) And also highlight that while they're related, the retail industry and retail real estate are two completely different things. (00:27:21) I mean, obviously there's a connection and a relationship between the two, but real estate is a hard asset which is occupied by retailers. (00:27:32) But the dynamics that are affecting certain retailers, that's a little different animal than what's going on in real estate. (00:27:39) But getting back to the high level narrative can impact anything that has the word retail attached to it, even if it's real estate, that's where we're seeing some opportunities being created. (00:27:50) So Rick, you want to flesh that out even more? (00:27:52) Yeah, I think it's exactly as my colleagues have kind of alluded to here, and you as well, that the retail theme, broadly speaking, has sort of encaptured (00:28:02) every single security and sector of securities in the market currently. (00:28:07) And that's clearly a broad brush set of assumptions. (00:28:11) And I think more specifically looking at retail, the business as Tom suggested just a minute ago is, there's really a delineation that has to be made within retail. (00:28:20) If we look at the 13 categories of retail and the penetration of e-commerce since its inception 20 years ago, okay, we have three categories that are losing a lot of share online and those are apparel, electronics, (00:28:32) in books and music. (00:28:33) Clearly, those are easily adaptable and scalable within that format, and so it makes sense. (00:28:38) And those market shares have gone from roughly high single digits to low double digits about five years ago to, you know, call it 20% today over the course of five years, more than doubling their share. (00:28:49) But the rest of the categories, which includes grocery stores, autos, etc., have barely budged from very low single-digit penetration. (00:28:57) So I think the story here is not the death of retail, but it is the death of a (00:29:02) apparel, okay? (00:29:03) And I think we have to be very specific about that because apparel lends itself to the online model. (00:29:08) It's got a very high cost to weight ratio, which makes it easy to ship. (00:29:12) You can order multiple items at a time. (00:29:15) So that business is under siege from online competition and structurally that's likely to continue, we think, for the indefinite future. (00:29:22) I think the key is that relates to real estate is that the mall business is very different from other retail formats, okay? (00:29:29) The mall business has very (00:29:32) high concentrations of apparel exposure, typically 50, 60% or more. (00:29:37) And then add on to that, you have department stores attached to the malls, which are typically 60, call it plus percentages of the square feet of a mall. (00:29:44) So those businesses are also mostly apparel related. (00:29:48) So all of a sudden, you have this very large scale format of real estate, and its exposure is highly concentrated in one retail category that is under siege. (00:29:59) That's problematic, we think. (00:30:00) And so yes, there is (00:30:02) a structural element to the mall business that we think is going to be a challenge for some time. (00:30:08) Kind of stepping back to your question about how do you formulate that into a trade and sort of separate the wheat from the chaff, and I think clearly everything retail is being sold and discounted out of fear and the broad narrative, but there are other formats of retail real estate such as shopping centers, grocery anchored shopping centers, which have been sold off equally and we think represent very compelling opportunities. (00:30:32) communities have been sold well below their intrinsic net asset values and are businesses that are structurally much better situated to continue to perform well and thrive. (00:30:42) Can you give, I want to give like a descriptive summary of the real estate in the retail sector kind of across the country. (00:30:51) So you've talked about malls and shopping centers. (00:30:54) If there was a pie, right, that represented all the retail real estate out there, the hard assets itself, the actual buildings and real estate, (00:31:01) How much is malls? (00:31:02) How much is shopping centers? (00:31:03) What are the other key categories that people should think about? (00:31:06) Right, so you have, call it, 100,000 retail assets, retail real estate assets, if you will, in the United States. (00:31:13) Roughly 1,200 of those are what we would refer to as a regional mall, the mall that everybody is familiar with that is, call it, half a million to a million square feet, anchored by two or three department stores. (00:31:25) And then you have variations below that, which include power centers, which are typically (00:31:31) anchored by a number of big box retailers with small shop tenants in between. (00:31:37) You have regional and community shopping centers, which have variant mixes of smaller boxes and small shop tenants. (00:31:44) Some are often grocery anchored, and then you have kind of a neighborhood center, which is a smaller scale format, which you would find in more of a residential area. (00:31:53) But all of these formats generally are suited towards people's everyday life, other than the mall, that is. (00:32:01) shopping center format is focused on lifestyle. (00:32:05) People go there to do their grocery shopping. (00:32:08) They go to get their hair cut. (00:32:09) They go to get their nails done. (00:32:10) They pick up their dry cleaning there. (00:32:12) They go and grab a bite to eat. (00:32:13) These are typically centers that are, you know, one to two miles from the typical customer's home, typically on their daily commute to work, to school, to wherever, and that is why these types of assets, okay, these shopping center assets, especially grocery anchored assets, are still (00:32:31) performing very well, the real estate is very well located, the businesses are not under siege from the internet. (00:32:37) I think we just were looking at some data very recently from a group I'll not name right now, but it showed foot traffic for malls versus shopping centers, and also broken down by grocery anchored shopping centers. (00:32:49) So mall foot traffic is actually in the second quarter down about 5% year over year, whereas shopping center traffic is up about 2% year over year, and grocery anchored shopping center traffic is up (00:33:01) up about 3%. (00:33:02) So very clearly you can see that this narrative about the death of retail requires a lot more nuanced analysis, and if you really dig down into the individual securities and businesses, you can see that there's really a lot of opportunity. (00:33:16) This raises a ton of questions, the first of which is to describe how kind of the mall, so the thing that's being most affected, how their business model works, like why is their success so integrated with some of these, the Macy's of the world that we've talked about that have gotten their (00:33:31) kicked in public markets? (00:33:32) That's a fantastic question because the mall format really was born out of the department stores. (00:33:39) So the department stores typically pay virtually no rent and the subsidy is in theory or at the onset of the business model was to the anchor department stores were the drivers of traffic, the primary shopping destinations. (00:33:56) Therefore, that traffic would be to the benefit of all the small shop tenants who pay much higher rents. (00:34:01) And that's typically the business model. (00:34:03) But today, that's been totally turned on its head, right? (00:34:06) So the department store anchors are now closing stores. (00:34:09) They're not the drivers of traffic anymore. (00:34:11) And I think, you know, again, this is another element of the business and the structure of it, I think, that presents a risk and a challenge going forward because now you're in a position where the mall owner has to go and explain to their small shop tenants (00:34:25) and justify why they should pay $35 or $40 or $50 rents when Sears, who's not driving any traffic, is about to close the store at the end of the mall, is paying $3, that dynamic and the leverage in that relationship seems like it's likely to change at some point. (00:34:42) For the malls themselves, you've seen some interesting speculation that, say, Amazon should buy Nordstrom or Amazon should buy one of these big box department stores really as, maybe even only as distribution points because the real estate that these places (00:34:55) zoned, I'm thinking about Macy's, tends to be prolific. (00:34:57) It's like in the best locations all over the country. (00:35:00) So what do you kind of view as the future of malls themselves? (00:35:04) If the business model is predicated on these kind of anchor tenants to pull people in and they're subsidized, what happens in the future? (00:35:11) I mean, malls take up some enormous real estate in some really interesting spaces. (00:35:15) How do you think that might be advantageously carved up by other players like, say, an Amazon coming in and buying one of these things? (00:35:21) It's an interesting question. (00:35:22) I think, again, we have to take a (00:35:25) step back down to the individual asset level and again, realize that there's great real estate and not great real estate. (00:35:32) And so the great real estate will probably continue to thrive in whatever format it's in, or if it has a department store anchor that is struggling and needs to close the location, it's likely very easily backfilled. (00:35:46) I think that's, again, to Jim's point about retail is not real estate, great real estate will always be in demand, it will retain pricing power, (00:35:55) whether it's Macy's or Sears or Dick's Sporting Goods or whoever is in it, if it's a well-located piece of real estate in a demographically attractive area, they'll be able to backfill it. (00:36:06) One of the trends we've seen is in some of the better located real estate is we've seen mall owners be able to go and backfill some of those anchor boxes with smaller spaces. (00:36:17) It requires a little bit of redevelopment, but backfill them with smaller spaces and other anchors that are paying higher rent. (00:36:23) So it's actually, in some cases, (00:36:25) has been a net benefit to well-located real estate. (00:36:28) I think to your question about Amazon and perhaps their desire or need, some might say, for physical distribution and a footprint, I think there was a lot of speculation prior to the Whole Foods deal that perhaps they would acquire one of these department store companies for that very reason. (00:36:43) And I, personally, I wouldn't rule that out in the future. (00:36:46) So how much of all of this, you did a good job describing the different types of retail real estate, how much of that is accessible through public market vehicles? (00:36:55) So, if you've got bonds that you can buy and sell, you've got REITs that you can use for exposure, how much of it is accessible to a hedge fund to be able to trade and potentially arbitrage on this insight, assuming it's correct? (00:37:06) Right, no, that's a great question and I think it really highlights the public REITs and their portfolios represent the cream of the crop, if you will, of the commercial real estate market. (00:37:19) So, of those kind of 100,000 retail real estate assets we discussed earlier, the public (00:37:25) REITs probably own the top 7,000. (00:37:27) So in terms of what is available in public markets, it's generally the top tier of that spectrum of the entire asset base, which makes it all the more interesting when you have a theme like this. (00:37:39) The expression of these views in public markets is almost by default not going to be very accurate. (00:37:46) So how high, just specifically high, has the correlation been with the shopping malls relative to, say, grocery anchored (00:37:55) shopping centers. (00:37:56) Has it been, are they down the same, literally down the same amount, kind of in contrast to that foot traffic stat you gave us? (00:38:01) Yeah, in this recent episode, they have been down from the peaks, call it nine months ago. (00:38:07) They were down almost the exact same amount. (00:38:10) They were both down about 40% from peak to trough. (00:38:13) So clearly indiscriminate selling and fear pervasive. (00:38:17) One of the things I always like to dig in on is, so if you've got a kind of contrary thesis for some subcomponent of this retail store, in this case, (00:38:25) shopping, not malls, but shopping centers, grocery anchored, maybe anchored by somebody else. (00:38:30) To ask the question, why won't the same thing happen to those retail categories? (00:38:34) So, if so far it's been primarily apparel and maybe electronics as a second one, why doesn't the same fate, is Amazon just gonna figure out some way of doing the same thing with these other categories? (00:38:45) Well, I think, I guess (00:38:48) The data would suggest in some of these other categories that have proven more resistant to internet adoption is, let's take grocery for an example. (00:38:57) And I think Amazon's recent acquisition of Whole Foods sort of validates the fact that that category is probably not ever going to be a large share of online sales. (00:39:08) And I think the principal reason is, as I mentioned in the survey data that comes back, is most people just don't want to, you know, they want to go and they want to pick out their own (00:39:18) meat. (00:39:18) They want to go and pick out their own dairy and produce. (00:39:21) I mean, for packaged goods, I think there's plenty of room for that business to be online, and it already is, I think, even among the traditional grocers. (00:39:30) But the meat and produce and dairy categories, I think people are always going to want to go and touch and feel their own food and not have that be in the hands of somebody. (00:39:42) somebody online. (00:39:43) So Joel, so your role is as head of research, and obviously that's a different angle than specifically focusing on one little niche of the market or other. (00:39:51) And I'm really interested kind of how you approach this same problem. (00:39:54) So if your mission, first, what is your mission, kind of overarching goal? (00:39:58) Where are you searching for inefficiencies and what is the process by which you're doing so? (00:40:01) Yeah, so basically I think as we've kind of harped on a little bit already, it's all about the real estate. (00:40:06) You have this broad narrative, you can't paint it with a broad brush. (00:40:10) If you have good quality real estate, and that's really at the end of the day what we're trying to find out. (00:40:14) We will get on a plane and go, like if we find a pivotal property to a particular CMBS bond we're looking at, we're not afraid to get on a plane, go look at the market. (00:40:23) We try to establish connections in all of these markets with brokers that know these markets very thoroughly. (00:40:28) Real estate brokers. (00:40:29) Yep, with real estate brokers. (00:40:30) And we try to get there. (00:40:31) We try to, we rent a car, we'll go around to the property. (00:40:34) We'll not only look at the assets, we're looking at the market, the competitors, the ingress, egress. (00:40:40) We're looking at how's the neighborhood. (00:40:42) Does it make sense for a Nordstrom's anchored center to have, you know, if the houses are (00:40:47) Much lower end, you have to kind of use common sense to some degree. (00:40:51) So it's all about the real estate, right? (00:40:52) And that's what we're trying to figure out. (00:40:54) Sometimes a lot of people in our industry kind of take a more macro view, top down approach, but we're definitely bottom up. (00:41:02) Like we actually go look at the real estate. (00:41:04) We were just offered a bond the other day. (00:41:06) Like great example, it was a community center, shopping center in a very affluent suburb of Chicago. (00:41:13) On paper, it checked all the boxes. (00:41:15) Great household incomes, household densities were great. (00:41:18) It was on a highway with pretty good traffic counts. (00:41:21) Looked great, but they had lost a couple tenants. (00:41:24) So we talked to pretty good contacts in Chicago and found out that there's brand new centers going to the north and the south. (00:41:30) This is old money in this area. (00:41:32) Traffic is definitely moving away from this center. (00:41:34) So we ended up figuring where this bomb was being offered to us made no sense based off the risks. (00:41:40) where somebody just topped out would have been like, oh, this checks all the boxes. (00:41:43) It makes me think of those scenes in like The Big Short where the guys fly down to Florida and they're asking the same sorts of questions. (00:41:48) They're like, what the hell is going on here? (00:41:49) You know, you can't believe that this isn't priced into securities. (00:41:52) Maybe give your favorite example of one of these kind of on the road examples of something crazy that you saw that maybe... (00:42:00) demonstrates the inefficiency that can exist once you get down to the very specific asset level. (00:42:05) I was just going through my, just trying to think about a bunch of examples. (00:42:08) There's been a lot of crazy stuff we saw. (00:42:10) Like one was a hotel, major market hotel, major brand, right in the heart of the downtown. (00:42:17) So on paper, it seemed like... (00:42:19) It made sense. (00:42:20) You're close to all the businesses and everything. (00:42:22) Saint Louis. (00:42:23) Yeah. (00:42:23) I didn't want to call out any markets, but we sent an analyst down there to look at this. (00:42:28) Yeah, exactly. (00:42:29) And my wife is from Saint Louis. (00:42:32) We sent an analyst down there to look at it, and they told him, frankly, at the front desk, Don't venture out more than one block from this building. (00:42:39) This guy was a little soft, though. (00:42:41) He actually put a chair in front of his door at night. (00:42:42) He felt so unsafe. (00:42:43) So this was, it looked great on paper, right in the middle of where you want to be seemingly. (00:42:48) But we went and it was just an absolute disaster. (00:42:50) Joe was very smart about sending his analysts to the site inspections where you have to borrow your door at night. (00:42:56) Yeah, I opted out of that one. (00:42:57) So let's talk a bit about the duration of something like this. (00:43:00) So... (00:43:01) A lot of people talk about how markets have become so incredibly efficient, so difficult to source any source of excess return above, say, real estate beta, however you might define real estate, public real estate beta. (00:43:13) So how long do these things tend to persist? (00:43:16) Is this sort of a trade that for your clients would be on for three months or three years? (00:43:21) And how do you assess when things have normalized? (00:43:24) What are the variables that you're looking for to say, okay, the inefficiency has been corrected, the relative pricing of malls versus other opportunities has closed, that inefficiency's gone, and we need to look for another trade? (00:43:35) Yeah, I think it's difficult to put an exact time horizon on the trade, but I think realistically, there are a number of catalysts that we're looking (00:43:43) that we think will sort of cause the reversion, if you will. (00:43:47) And that time horizon is probably anywhere from six months to a couple of years, it could be. (00:43:54) And I think some of the catalysts that we're looking at are, one, in shopping centers, given their much smaller sized assets, there's regular price discovery. (00:44:04) These assets are, call it $10 to $25, $30 million, maybe $50 million. (00:44:10) They trade regularly, almost every day. (00:44:12) And you can see (00:44:13) to see what's happening with the pricing in the real world in various markets all over the country. (00:44:19) So one, you have regular and pretty visible price discovery that ultimately I think will, assuming no changes and there haven't been so far, that will continue to wear on the bear case, if you will. (00:44:29) Some of the other catalysts are, one, just the operating results of the public companies that are owners of portfolios of these assets. (00:44:36) They've been very solid, better than expected, continuing to perform well. (00:44:40) And I think as that continues to play out, (00:44:43) particularly relative to some of the mall owners whose results have not been very good and have been below expectations and trending negatively, I think the longer that divergence continues to be visible in public markets, that will drive the reversion over time. (00:45:00) The last catalyst is we think that the disconnect here is so extreme that we would be not surprised to see either public-to-private M&A or public-to-public M&A, frankly. (00:45:12) So just to close out this section, this kind of really deep dive on an individual idea or trade, without giving the actual positions, just give a flavor for how you actually position the portfolio across these different securities. (00:45:23) So if you've got REITs and you've got bonds as ways of being long and short, these kind of two categories, how does that actually come together in a portfolio? (00:45:31) At least in CMBS, and I'll touch on REITs, I mean, CMBS, we definitely tend to construct the portfolio at least a little bit more top-down thematically, originally based on what (00:45:42) What's our goal here risk-return wise? (00:45:44) What's our view of the market? (00:45:45) We then go bottom up the security level. (00:45:47) At the end of the day, it's all about security selection, especially in CMBS when you're playing the bottom of the capital structure. (00:45:52) But you first need to understand how the different themes and securities in the portfolio are going to interact, especially under stress. (00:45:58) With REITs, it's the same way. (00:46:00) I mean, Rick, can you give a little window into how you think about portfolio construction on the REITs side? (00:46:04) Sure. (00:46:04) I think the portfolio construction is driven by, one, the bottom-up individual security analysis. (00:46:12) we go very, very deep down to the asset level, which is frankly one of the benefits of having a team that looks at all parts of the capital structure, having Joel and his team available as a resource to help analyze individual assets. (00:46:27) So we look at a portfolio in a very granular way and formulate our own sense of net asset value. (00:46:34) And then from there, (00:46:36) we're really focused on the risk versus the reward. (00:46:39) And so we want that asymmetry and where it is largest, based on our analysis, we size positions accordingly. (00:46:47) We have a lot of tools available to us that allows us to construct a portfolio to get the risks and exposure to those risks that we want and to hedge out the ones that we don't. (00:46:57) So between (00:46:59) The CMBS market, which has a very large and liquid derivatives market with about 30 different tranches that we can use to either be long or short. (00:47:09) And then the REIT equity market, which has 150 or 200 names across a lot of different property types and individual operators. (00:47:18) And then you bring in certain ETFs and other liquid market indices. (00:47:22) You can craft a portfolio that really allows you to be pretty specific and pretty direct on the exposures that you're seeking. (00:47:29) So for example, this shopping center theme, and there's some select shopping centers that we feel are 30 to 40% discounts to their underlying real estate value. (00:47:40) That's what we want exposure to. (00:47:42) And so we want to isolate trying to capture that huge discount, but we really, we don't want equity market beta, we don't want broad REIT market beta. (00:47:50) We don't want exposure to more big headlines in the retail and apparel industry, but we have enough tools that we can manage a portfolio of hedges against what it is we're seeking to get exposure to, where we can really isolate things. (00:48:05) Yeah, that's exactly kind of what I was getting at, which is, as I hear you guys talk about the dislocation, what it sounds, what the opportunity sounds like is effectively a market-neutral pair trade, that you get exposure to things that have the baby that's been thrown out with the bathwater and can benefit regardless of what (00:48:20) that happens at the macro level. (00:48:22) But it begs the question then, why has this persisted? (00:48:24) Like why haven't others come in and taken similar positions with enough size to close that gap? (00:48:30) Yeah, I mean you asked before about is the market efficient? (00:48:34) Eventually, markets I think are reasonably efficient, but defining how long eventually is depends on the specific sector. (00:48:43) When you get into the liquid end of the commercial real estate sector, which is CMBS and REITs predominantly, (00:48:49) Yeah, I think we talked about it earlier. (00:48:51) It's dominated by a lot of indexers and people that are just looking to get sector exposure, and there's not as many true specialist investors seeking out hidden value as you would think. (00:49:05) So these types of opportunities in CMBS and REITs, they can persist for a while, but eventually the fundamentals bear themselves out, or eventually the non-sector specialists (00:49:17) find it and get enough expertise through other formats to get involved. (00:49:22) But I think it does come back to both the CMBS and the REIT sectors have predominantly beta-oriented investors that are just seeking sector exposure, which leaves a lot of opportunity for specialists seeking mispriced value. (00:49:36) I would love to hear your guys' take on this meme that I've heard from a lot of people, which is that the growth of passive ETFs and passive investing style has (00:49:46) lengthen the time over which maybe some of those inefficiencies would be corrected. (00:49:50) There's always this idea that being too early in our business is indistinguishable from being wrong, and so you may have identified the proper trend, but the timing of it could last so long that your clients don't stay the course, you don't stay the course, and I've heard this used like when I read hedge fund quarterly letters. (00:50:06) This is a common excuse, I'll say, which you could argue hedge fund managers should be updating their expectations based on this change in market dynamics, but how do you think (00:50:16) the role of people, say, buying VNQ or buying beta in these spaces affects the timeliness of your edge. (00:50:24) Do you think that that's right, that it's distorting things and maybe it'll happen eventually, but timing is a bigger question? (00:50:31) From my perspective, that's absolutely true. (00:50:33) I think there's no question that the influence of the passive flows have had, particularly in more concentrated spaces such as REITs and real estate has definitely had an impact. (00:50:45) And I think you're (00:50:46) assessment that has probably lengthened time horizons in general is probably also correct. (00:50:52) That said, kind of thinking about this particular theme in trade as we're thinking about it, being cognizant of those factors as we are, we also think that the catalysts that we've identified are likely to make that time horizon more tangible probably than generally would otherwise be the case. (00:51:09) And the other angle to that too, Patrick, is (00:51:12) Now being aware of that, it can create opportunities because those flows can be powerful. (00:51:16) I mean, you know, we've got a couple of examples of things, REITs that we think are very overvalued, but when there's big flows coming into a sector and they're part of the index and you start getting those ETF flows that have to buy everything, you can see some things that we think are very overpriced become ridiculously overpriced, I mean, to the tune where, you know, we think, (00:51:40) The REIT has it priced at almost 100% premium to the reality of its underlying real estate. (00:51:46) But you've got to have the timing right, and you better be aware of those flows because, there's a great comment you made, being early sometimes is indistinguishable from being wrong. (00:51:55) But you've got to factor these things in when you're trying to express some of your value-oriented investment themes. (00:52:02) I mean, all that you guys have talked about has been very bottom-up in terms of structuring the portfolio. (00:52:07) I'm curious how much, if at all, you care about momentum? (00:52:10) One of the things we found in the quantitative world is for, say, a value strategy. (00:52:14) If you just overlay a momentum strategy into those value names, it can be a really powerful way to get rid of that problem of being really, really early, wait for a little bit of a turn. (00:52:23) Do you care about momentum when you're thinking about these things? (00:52:25) Just to comment on CMBS, and then we can talk REITs, at least in CMBS, this kind of relates back to your last point, right? (00:52:30) So obviously, the passive flows and dominate. (00:52:33) And I think when you're trading a credit instrument like CMBS bonds, (00:52:38) You don't have a liquid functioning market. (00:52:40) You have runs to figure out where you should be that morning, but frankly, most guys are looking at what the corporate credit market's doing, and they're definitely looking at what the S&P futures market is doing. (00:52:50) And so it's funny because we're in this illiquid long-duration product, yet guys are pricing risk based off of the S&P 500. (00:52:56) And I think that the reason that a lot of people get hurt in CMBS is because they don't understand this phenomenon that CMBS is typically 10-year loans, so it's a long-duration asset. (00:53:07) in looking at the underlying loans, what you'll see is that CMBS will tend to trade very macro. (00:53:13) You're kind of trading macro, so the momentum's important. (00:53:16) So which way is the S&P 500 going? (00:53:18) What are credit spreads doing? (00:53:19) That's important for the first seven years. (00:53:21) The last three years, though, is where you're trading the credit, where you're trading the idiosyncratic risk. (00:53:26) And I think that's where we have the most edge at those points. (00:53:29) We're in one of those inflection points right now, right? (00:53:31) So here we stand today with the S&P 500 within basically at the highs. (00:53:36) and you have corporate credit pretty close. (00:53:38) It's definitely been underperforming because it's hard to keep up with stocks here. (00:53:41) When you look at the bottom of the capital structure in CMBS, you're seeing a totally different story. (00:53:46) If you look at just even the indices, they're off probably 15 points from their high over a year ago, despite being over a year shorter. (00:53:52) So I think that what that tells you is that you get to a point, especially with credit, where people start to look at loss-adjusted spreads. (00:53:59) It's no longer just trading momentum. (00:54:01) It's, okay, now I need to think, how are these pools going to perform through a cycle? (00:54:05) What's going to happen? (00:54:06) Where am I? (00:54:06) Where's the fulcrum part of the capital structure? (00:54:08) Am I on the right side of that or am I on the wrong side? (00:54:11) And so that's when you can see the capital structure steepen. (00:54:13) You start to see a lot more dispersion in between one bond and another bond for various reasons. (00:54:17) And so that's where we definitely have more of an edge. (00:54:20) In 2011-12, it wasn't hard to make money in CMBS. (00:54:24) I think right now you're seeing a lot less active management on the hedge fund side in CMBS, for one, because spreads are so tight. (00:54:30) Well, actually, I guess I just told you we're 15 points off the highs from (00:54:34) from 18 months ago. (00:54:35) So that isn't necessarily the case, but there's still a lot more people involved because it just requires so much more work now. (00:54:40) Because back to your question, you can't trade momentum right now. (00:54:44) You're in an illiquid credit market, and at some point here, we're gonna see the other side of the cycle, and you need to be a specialist when that happens. (00:54:51) Yeah, that's super interesting. (00:54:53) How evenly distributed are the vintages of these 10-year cycles? (00:54:56) So do they tend to cluster? (00:54:58) Are there periods where in a given year there's a ton of (00:55:01) of origination of the loans and 10 years out, there's going to be kind of this closing three-year opportunity, or is it pretty evenly spaced through time? (00:55:08) So kind of every year you've got some batch that's coming into this kind of last three years of its cycle. (00:55:14) So I mean, I think it's best to just talk post-crisis for now, because we can talk pre-crisis, so that's a very different story. (00:55:20) You certainly see a lot of tiering in between the different vintages. (00:55:22) For example, 2012 within CMBS was very retail heavy. (00:55:26) So that's where the guys who are coming in and trying to express that negative view on retail are looking to short (00:55:31) and expressed that view by getting short that particular vintage, just because retail was as much as 40% of some of these deals. (00:55:38) Whereas now what you're seeing is that in the 2017 origination, there's effectively no retail. (00:55:44) There's definitely very little malls. (00:55:45) Retail's a very small component. (00:55:47) But the trade-off is we have more suburban office. (00:55:49) We have more lodging at a time late in the cycle. (00:55:53) And so I think there's always a trade-off. (00:55:55) I mean, Joel, do you have any comment about, over the years, and Joel's been following CMBS since the beginning of the product, like Jim, so he definitely has a good perspective. (00:56:01) Yeah, no, retail was kind of the bread and butter. (00:56:04) One of the major, it's typically, if not the, it was the top or the second highest concentration in CMBS over the years. (00:56:11) And they really had a lot of mall loans were kind of one of the big, the bail out of at least maybe two or three mall loans in every deal in the previous cycle. (00:56:20) But 2012, the market effectively shut down after the crisis. (00:56:24) And then the CMBS market gradually started each year, got a little bit more issuance. (00:56:28) So early on, you saw a lot of malls, 2012 kind of being key. (00:56:32) And then there became a little more pushback over the years. (00:56:35) And now you're seeing one mall in a deal. (00:56:38) And it's really like the CMBS market's pretty reactionary. (00:56:42) Everybody's afraid of retail now. (00:56:44) It's gone from 30%-ish to now it's down to 20%, and I suspect that's going to come down even further. (00:56:50) But you have to kind of be careful what you wish for, because as Tom mentioned, we're kind of getting more exposure to sectors that aren't necessarily much (00:56:58) better, like suburban office right now is greatly increasing. (00:57:01) You're having lodging, like things that we're a little more concerned about, longer term, a little bit more multifamily. (00:57:07) But as an active long-short manager, this is what we want, right? (00:57:10) We don't want all the vintages to look the same. (00:57:12) It's great when they price the same, because then we can put on other relative value trades, and there's always different ways to try and take advantage of that. (00:57:20) which is why it's important to have the index, which is unique to CMBS, that we have a pretty liquid CMBX market, which have, you know, you have 10 different series, you have triple-A down to double B, so you have 6 tranches of each, and it's 25 deals that are supposed to be representative of that given index. (00:57:38) of that given vintage. (00:57:39) So we have kind of right now, post-crisis, 60 different bets we can make right now on, at one point, and there's 10 series right now, so you effectively have 60 different tranches. (00:57:49) You mentioned this idea of deep, fundamental, bottom-up, value-oriented work. (00:57:53) Can you describe, you could use them all, you could use any piece of commercial real estate or any real estate security, maybe a fun example of one that you've done a deep dive on, and specifically the kinds of things that you're looking for. (00:58:06) Again, I'm coming at this from (00:58:08) a more traditional, like I'm used to the other public equity sectors, and even more specifically quants like us typically exclude REITs completely because the notion of earnings really doesn't make sense. (00:58:18) A lot of the things that you would normally care about for equities just don't apply to REITs. (00:58:22) So it'd be interesting to hear what factors you're specifically looking at, like what is that actual process for deciding from the bottom up whether a particular security is attractive or not? (00:58:33) So we have an 11-person investment team, which for a firm of our size, which is about (00:58:38) about a billion of capital under management, it's a pretty big investment team. (00:58:42) And just to kind of put that into perspective, some of the world's largest money managers, some pretty household, big household names, their CMBS investment group might have two or three people. (00:58:53) And again, that's more of a commentary that they're really out just getting sector exposure and they're not really necessarily true credit investors. (00:59:01) So we have an 11 person investment team of which (00:59:05) four or so are spending all of their time looking at properties. (00:59:09) So we view ourselves as commercial real estate investors that operate at the liquid end of the spectrum. (00:59:15) So if we're looking at a CMBS bond, we're looking at the underlying real estate. (00:59:20) So a bond might be, a particular deal might be backed by 100 loans on 100 different properties. (00:59:27) And maybe the top 10 largest loans account for 40 to 50% of that pool by balance. (00:59:33) and you're looking at the top 20, maybe top 30 properties, some of which you can do a desktop underwriting, a lot of which you're getting on airplanes and you're going and visiting properties. (00:59:44) So it is a blocking, tackling, grinded out, intensive research process, but there's no way around it because the building blocks for CMBS and REITs are individual properties. (00:59:55) And if you don't have an opinion on the underlying individual properties, (00:59:59) can't really have an opinion on the intrinsic value, recovery value of a bond or the NAV of a REIT equity. (01:00:05) Any favorite stories from the kind of boots on the ground site visits to different securities over the years from either of you? (01:00:12) Yeah, I would say that what's unique about our approach is that being involved in both CMBS and REITs is a lot of... (01:00:20) synergies and positive externalities to being in both spaces. (01:00:22) There's information sharing and things that you're seeing on the public side that may be on the public equity side that is very good information for a given bond investment we're looking at. (01:00:31) One that comes to mind is a more seasoned bond they were looking at. (01:00:36) So it was a pre-crisis bond that at one point had 196 loans. (01:00:41) At this point, it had 12 loans left. (01:00:43) This bond was originally rated triple B minus, so it was what you consider to be a fulcrum security. (01:00:47) Describe fulcrum security. (01:00:49) So when we think about it, we're looking at, okay, you have a cash flow waterfall and you have bonds with various levels of subordination. (01:00:57) The bonds higher up, the triple-A bonds have much more credit enhancement than the more subordinate bonds that are gonna be generally thinner and have less cushion from loss. (01:01:06) And so depending on the vintage, the loss might be higher or lower. (01:01:11) But when I say fulcrum bond, it means that it's going to be the key bond right around where the losses are going to be. (01:01:16) So generally, it's going to be the bond where it's either going to be... (01:01:20) Kind of the demarcation line. (01:01:21) Yeah, exactly. (01:01:22) Above that line, bonds are safe, and they're going to get par back below that line. (01:01:27) they're going to take losses, maybe 100% losses. (01:01:29) So it's kind of that. (01:01:30) So it creates a lot of opportunity. (01:01:32) And this particular bond had recently taken a loss, it had probably been trading up close to par, and had recently taken a loss and was now the first loss piece, so the most junior piece, as losses all flow, reverse sequential, up the waterfall. (01:01:47) And so this bond was owned by an insurance company, and the insurance company was not in the business of owning first-loss bonds, is my understanding. (01:01:54) And so the portfolio manager said, sell the bond. (01:01:58) All else equal, after the losses come through, you're actually looking at a cleaner pool of loans. (01:02:02) And so the bond should actually trade higher in price. (01:02:04) That's just basic bond math. (01:02:07) In reality, though, given that these are illiquid assets that we're talking about, we were looking at this bond, and it was clear that they were a motivated seller. (01:02:16) We went and looked at the loans. (01:02:17) So you had 196 loans originally. (01:02:19) At this point, there were only 12 loans left. (01:02:21) And it was pretty easy to figure out which loan was going to define the outcome of this bond. (01:02:26) 11 of the 12 loans were New York City co-op loans. (01:02:29) Historically, New York City co-ops have never taken a loss in CMBS. (01:02:33) So it's pretty safe to say that those we didn't really need to look at. (01:02:37) Even through the crisis. (01:02:38) Even through the crisis. (01:02:39) So on top of that, though, those loans only represented 2% of the pool. (01:02:43) So really, what was left was a loan, and it was on a shopping mall, and it was on a regional mall, I should say. (01:02:50) And the important thing here is that a lot of people would say, okay, I don't really want to do the work here. (01:02:55) This is very difficult. (01:02:56) Now I'm first loss effectively on a mall. (01:02:59) If you're sitting at your desktop in New York City or here in Stamford, Connecticut and trying to underwrite this, it's pretty difficult because at the time, we were still, the market has since recovered more since, but at the time, this asset had probably 80% occupancy, which isn't that strong. (01:03:16) There was, if you looked at the notes on Trep, which is the service provider people use in the space, there wasn't very many positive things to look at. (01:03:23) But it was a mall that had been spun out of GGP, which is a REIT, had spun out a portfolio of some of their lower quality malls into an entity called Rouse. (01:03:32) We were familiar with it because we also invest on the REIT side. (01:03:35) And so, one of our analysts said, Oh, that's Rouse, I've actually seen the property, have spoken with management. (01:03:41) It's clear, based on conversations we've had, that they're actually committed to the asset. (01:03:46) And that if you actually just did some digging, which any REIT investor you spoke to probably could've uncovered that, (01:03:52) They had a decent plan to continue to put money into the assets. (01:03:55) They had already had some pretty big leasing progress and brought 4 pretty solid tenants in. (01:04:00) And then when you actually looked at the fact that it was, it was clear that this was a high probability of being a layup refi in the next 12 months. (01:04:09) We bought this bond based on all that information at 50 cents on the dollar. (01:04:13) We were owed 9 points of coupon that had yet to be paid to that bond. (01:04:17) So effectively your new PAR is now 109. (01:04:20) And it ended up paying off, I think, in (01:04:22) under nine months on that one. (01:04:23) So that's a unique example there of being involved in both REITs and CMBS and being able to kind of piece together something to put-- And all the info is out there in the public domain. (01:04:36) You just got to dig. (01:04:36) Tell me your story about how you guys connected at first. (01:04:39) I know all three of us are Notre Dame guys, so that's part of the story, but I'd love to hear what the origin story was for your partnership. (01:04:47) From me or Jim, I don't even know which is funnier. (01:04:51) I mean, I guess it's probably, you can hear both sides. (01:04:55) For me, so as you mentioned, you and I were same year at Notre Dame, and I was one of those kids who worked my butt off in high school. (01:05:02) But once I got to college, going to Notre Dame, I was like, I'm done checking out. (01:05:06) And I had other interests. (01:05:07) I had other interests in school until... (01:05:10) I think it was summer between sophomore and junior year. (01:05:12) I just started reading a lot and I was reading about finance and I read Ugly Americans and Liar's Poker and Barbarians at the Gate and all those good ones, mostly from the 80s and 90s. (01:05:22) And I said, wow, this seems fun. (01:05:24) It didn't seem like what they were talking about in corporate finance class. (01:05:27) It was actually, it was hard hitting and fast and it was work hard, play hard. (01:05:31) And I was like, I could do that. (01:05:32) sounds fun. (01:05:33) And then all of a sudden I went and saw a college advisor. (01:05:36) He's like, well, no one's gonna hire you. (01:05:38) Your grades aren't that good. (01:05:39) He's like, you've been, (01:05:40) it says here you didn't go to half your classes. (01:05:43) And so then I started really applying myself and I got good grades junior year. (01:05:46) And then sure enough, senior year, I was interviewing because I thought I wanted to go into investment banking because that's what you're told in college. (01:05:54) And every investment banking interview, whether it's Goldman or someone else, I was sitting across the table. (01:06:00) at the Notre Dame Career Center with a kid that was maybe a year older than me, telling me that my grades aren't good enough. (01:06:06) And I'm telling him, hey, can I talk to your boss? (01:06:08) Because I have no interest in talking to you. (01:06:09) And it's going through the interview process, nothing's clicking. (01:06:13) And then I see that I'm interviewing with Soren Capital. (01:06:17) I can't really figure out for the life of me what it is. (01:06:19) So I figure it must be a hedge fund. (01:06:21) And then I'm Googling it and I see the name Jim Higgins. (01:06:24) I'm like, why is that name familiar? (01:06:25) I'm like, oh, I'm meeting with that guy. (01:06:27) I'm like, I'm finally meeting with someone who's not 23 years old, who has the ability to make a call on someone's character. (01:06:34) And then I finally said all the things my father told me to see in the interview. (01:06:37) It was basically just, you know, all that cliche stuff about running through walls and, you know, don't look at my resume. (01:06:42) I'll work harder than the next guy. (01:06:44) And he fell for it, so. (01:06:47) I don't know if I fell for it, but so this was fall of 2006, and we at this point had pretty strong views that there was major problems going on in the structured finance markets, in particular residential, and that there was potentially a big disaster coming up, right? (01:07:04) You're hearing about people getting mortgages left and right. (01:07:08) People are, you know, (01:07:09) originating mortgages out of nowhere. (01:07:12) So I'm interviewing Tom and then I see something about mortgage origination. (01:07:16) And I said, what is this in your resume? (01:07:18) He goes, yeah, I'm originating mortgages out of my dorm room. (01:07:21) And I literally said, can you hold on for a second? (01:07:23) I went out and called back at the desk. (01:07:24) I go, our thesis on shorting the residential mortgage market is right. (01:07:28) I got a kid here who's selling mortgages out of his dorm room. (01:07:32) It is as bad as we think it is. (01:07:35) So, we had a good conversation, and I looked past the, his grade point average was probably around his mind. (01:07:42) He got it up. (01:07:43) I saw the upward trend. (01:07:48) Value and momentum. (01:07:50) So I said, all right, he looks like he hustles, and let's give him a shot. (01:07:54) So we had our own version of a Super Saturday, and we called like 6 candidates back. (01:07:59) I think it was two or three Notre Dame kids and two or three Princeton kids, and afterwards, and we're all kind of going through it, and I didn't want to be a Notre Dame homer and, support the Notre Dame kid only, so I was kind of leaning towards one of the Princeton kids. (01:08:13) And one of my junior guys who was going to be the one that was going to have Tom work for us said, no, I like him. (01:08:18) I think he's going to hustle. (01:08:19) He said, okay. (01:08:20) And he was a Princeton guy too, which was the ironic part. (01:08:22) So as they say, the rest is history. (01:08:25) Love it. (01:08:26) So then what was the experience, Tom, just like me, started with a couple months, I guess in real estate, it started sooner, but in equity markets, I had a couple months of bull market and then the worst crash that we'd all seen. (01:08:36) So what was that experience like working together early on? (01:08:39) I think at the time you were primarily doing trading. (01:08:41) So what were the lessons learned? (01:08:43) learned in obviously a really sensitive part of the markets. (01:08:46) And I know commercial real estate weathered the storm better than residential, but what must have been a really incredibly hard time. (01:08:52) Yeah, I mean, so many lessons coming out of the crisis. (01:08:56) It was definitely a young guy on the desk working at a hedge fund. (01:08:59) You get a lot more responsibility than you probably should get just because there's only so many guys on a desk, so everyone's got to carry their weight. (01:09:06) I think that there's plenty of lessons that we could talk about trading and investing, but I think the more important lesson, especially as I sit here now as a portfolio manager and a fiduciary of Investors Capital, is that I remember in the depths of the crisis, speaking with colleagues at other firms, and they were talking about how... (01:09:24) They were using mechanisms that would allow them to basically put up a gate or prevent funds from leaving. (01:09:32) And there's obviously different rationale for that. (01:09:34) And I remember talking to Jim and he said something that I'll never forget, which is that, Tom, this isn't your money, never forget that. (01:09:41) We don't know what's best for the investors. (01:09:43) If to their money, if they want it back, then we have to do the best we can to get it back for them with the highest recovery possible. (01:09:50) in a very difficult and challenged market. (01:09:52) And that's something that certainly resonated with me. (01:09:55) And yeah, I would say that was probably one of the bigger lessons. (01:09:57) How about you, Jim, coming through the crisis? (01:10:02) Feels like a few lifetimes ago. (01:10:04) Lots of lessons, both as a manager of people and also as a manager of money and a fiduciary of money. (01:10:11) Overall, again, I think we definitely would have done some things differently on the investing side. (01:10:16) We had, I think, the big themes and the big theses right. (01:10:19) We probably ended up in some investments, both on the long and the short side, that we convinced ourselves were liquid. (01:10:27) And they were generally liquid in a bull market, and then they weren't liquid at all when things turned. (01:10:32) And so we couldn't adjust the portfolio as quickly as we would have liked to. (01:10:38) It's OK to take illiquidity risk on the alpha side of the trade if you feel you're really being compensated for it. (01:10:44) We took some illiquidity risk on the hedge side of a pretty big trade, and that got us trapped and ended up kind of eating away all of our profits on one particular long-short trade, so don't take illiquidity risk on the hedge side of a trade. (01:10:59) And then also, know what you're good at and stick to it. (01:11:03) I think this industry can lead to some hubris at times, and when you're good at one thing, you start to extrapolate that it applies to a bunch of other things, and so we (01:11:14) did doing some investing in the residential and the ABS space, where we actually did okay, but it wasn't our pure expertise. (01:11:22) And so stick to what it is you really have a definitive defined advantage in. (01:11:28) And then it also led us to the evolution of our business model, which was away from the co-mingled hedge fund (01:11:35) Manager-centric model, where it's saying, This is what we want to do, and we're trying to get you to do what we want you to do, and go more towards the client-centric model and saying, Here's what we do, here's what we find interesting. (01:11:48) how can we help you with your goals, your needs, and let's see if we can do something customized to it. (01:11:53) Can you talk a little bit more about that? (01:11:54) Because this is a big trend in asset management in general, and just your particular experience is probably good evidence of this, where the history has been here, buy my product, right? (01:12:04) Like it's try to jam an individual product or set of products. (01:12:07) to every investor. (01:12:08) We talked earlier about the motivation behind CMBS, the entire asset class is that different investors want different things and tranching things out and having different securities can meet different needs. (01:12:20) So what does that look like when someone comes to you, let's say a big institutional allocator or something, what's kind of the range of when you say, we'll give you what you want or we can effectively take our brain in this space, which is to understand real assets, but also structured finance, and we can kind of tailor that to (01:12:37) to a particular outcome that you want. (01:12:40) What are the things that people want? (01:12:41) What is the demand or the range of demand from institutional investors or any investors that you're talking to? (01:12:47) So, I mean, it really all started in 2010, which is we had returned all the capital, we had liquidated all the assets and returned capital to the investors of that original fund. (01:12:57) And a client, very, very large, one of the world's largest pension funds, their alternatives group, which they manage money out of New York. (01:13:06) said, Look, we want you to manage money for us, but we don't go into commingled funds. (01:13:11) We'll give you X hundreds of millions of dollars into a fund of one, and here's what we would like you to do. (01:13:18) But it wasn't, Oh, invest in this, invest in this, invest in this. (01:13:21) It was more parameters in terms of the returns they're looking for, their risk tolerances, and the types of risks they don't want exposure to. (01:13:34) very clear on defining how they defined alpha. (01:13:38) They didn't want to be short a GDP tail. (01:13:40) They didn't want to really have a lot of true beta exposure. (01:13:45) But what they also understood was to achieve alpha, you can't think in monthly, quarterly, or even annual timeframes. (01:13:52) They said to us, Think in two to three-year timeframes. (01:13:55) We're okay. (01:13:57) with drawdowns if it makes sense. (01:13:59) We understand that in order to achieve high quality returns, you can't be thinking in short timeframes. (01:14:06) And to us, this was like manna from heaven. (01:14:09) They were big, they were sophisticated, they thought in appropriate timeframes, they gave us very clear guidance on what it is their tolerances were, and then they left us alone to do it. (01:14:19) We talked with them once a month or so just to give them updates on what's going on. (01:14:23) But that's what really clicked to us is we need to find the right investors, the right partners, because that's really how we view them, where what it is our philosophy is and what it is we can deliver matches with what they're looking for. (01:14:37) I wonder if that's how the industry will go in general, not just in one particular asset class, but basically like a return profile that people are after, where it's not the most upside. (01:14:46) Maybe it's more defined by I can withstand a 15% drawdown and that's it, and I can't go worse than that. (01:14:51) So just give me the most upside you can, (01:14:54) but do not breach that 15% downside. (01:14:56) And that's kind of this one client, right? (01:14:57) I think they're looking for 10% to 12% returns over time, uncorrelated, and they can withstand 15% drawdowns if it makes sense. (01:15:07) And it's more, it's not mistake driven. (01:15:10) It's just, hey, the pricing of the assets kind of can come and go. (01:15:14) We have another client, a very large Asian bank that is looking for 6 to 8% returns with very low price volatility, carry driven, not a lot of leverage, and not taking a lot of duration risk as well. (01:15:30) And so we were able to solve for them, and it's very different, and the fee structure's different. (01:15:35) I mean, again, ultimately, we should be trying to deliver a high quality value proposition to clients. (01:15:41) and that means delivering what it is they're looking for at appropriate pricing, right? (01:15:46) Not everything should be 1 1/2 and 20, I don't think anybody's getting much of a full fees like that anymore, but not everything is incentive fee driven. (01:15:54) Some stuff should just be management fees, some should be lower incentive fees, some should be lower management fee and much more higher incentive fee driven. (01:16:01) So really, again, it all depends on (01:16:03) the amount of complexity, the amount of alpha, the scarcity. (01:16:07) I mean, there's a lot of factors that go into how you price some of this. (01:16:11) And so, we probably have six different profiles that we're delivering to a range of clients currently. (01:16:17) Some are value investing. (01:16:19) There's another strategy we have now kind of tying back into the regulatory topic. (01:16:25) Regulatory changes can create opportunities. (01:16:27) And one of the big regulatory changes that's happened over the last few years has been increased regulatory capital requirements on banks and broker-dealers. (01:16:36) And so basically what that means is for certain assets that broker-dealers and banks hold, they've had to hold a lot more capital against them than they have in the past. (01:16:45) And in particularly in fixed income structured product securities like CMBS. (01:16:51) Broker-dealers have to hold an extraordinary amount of capital today relative to what they did three, four, five years ago, and that has completely changed the secondary trading landscape. (01:17:03) So for decades, the secondary trading desks on Wall Street were principal secondary traders, meaning they would buy and sell bonds, and they would hold pretty good-sized inventories, and when you wanted to bid on something, (01:17:16) They'd say, sure, here's our bid, and they'd position it, and they'd hedge it and sell it later. (01:17:21) And they made good money doing that. (01:17:23) With the capital reg requirements going up so much, they can't hold the kind of inventory that they used to, because they just can't make the ROEs work. (01:17:31) And so what you've seen is the secondary trading desks have gone to being almost exclusively agents and intermediaries, and no longer principal secondary traders. (01:17:41) We noticed that a couple of years ago and it changed how we were doing some things in our portfolio because the liquidity wasn't there the way it had been. (01:17:48) And then we started thinking about, okay, things have changed. (01:17:51) Is there an opportunity here? (01:17:52) And so we saw an opportunity much like the shadow banking industry arose to fill in some of the blanks in the lending universe where banks pulled back from. (01:18:03) A similar thing has arisen on the secondary trading side where as the broker dealers are pulled back from principal secondary trading, there's opportunities for private funds, private firms, non-regulated firms to step in and to do some of those activities. (01:18:17) And so we have a strategy or a theme that we're delivering to some of our investors that's more of an active trading strategy where we're doing some of the activities that being willing to price risk (01:18:32) hedge market risk and get paid for doing it. (01:18:34) So it's not really a prop trading strategy. (01:18:36) It's not saying, oh, we're going to make big bets one way or the other. (01:18:39) It's really it's performing a service or a function for the market and getting paid for it. (01:18:44) So that's an example of how regulatory changes change the landscape pretty dramatically in terms of liquidity. (01:18:51) But then it created an opportunity because something had changed. (01:18:56) And that's probably one of our highest conviction (01:18:59) themes that we have at the moment and have raised a decent amount of capital for it just in the last 12 months. (01:19:04) Do you guys see other traditional hedge fund firms or hedge fund firms that you know that are making this same transition from, here's our co-mingled fund, you know, we're just going to do our thing, to more, I don't know what you want to call it, like solutions-based or client demand-driven investment strategies? (01:19:21) Or are we still in fairly early innings of (01:19:24) of that transition happening? (01:19:26) I can't say that we've seen it in our space, and I'm sure it is happening to some extent. (01:19:30) I think that we're just taking a much more proactive approach with it because it became clear to us with some of our clients, which are unique in that we have very large, sophisticated investors who do need a range of different profiles. (01:19:44) So it kind of came about in a reverse inquiry for us. (01:19:46) But I think, yeah, so I can't say that we're seeing it in our space as much.