Ep. 43 The Long-Short | In conversation with award-winning author Sebastian Mallaby

Published: 26 October 2022

The Long-Short is a podcast by the Alternative Investment Management Association, focusing on the very latest insights on the alternative investment industry.

Each episode will examine topical areas of interest from across the alternative investment universe with news, views and analysis delivered by AIMA’s global team, as well as a host of industry experts.

This week, The Long-Short had the pleasure of speaking to Sebastian Mallaby, a Paul Volcker senior fellow for international economics at the Council on Foreign Relations as well as a multi-award-winning author and journalist. His best-known books on alternative investments include More Money Than God, a comprehensive history of the hedge fund industry, while his latest book, The Power Law, lifts the lid on the venture capital market.  

Sebastian spoke to us about his writing process, his take on the evolution of the alternative space since his hedge fund book was published just over a decade ago and gave a hint of which area of financial markets may be the focus of his next work.

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Hosts: Tom Kehoe, AIMA; Drew Nicol, AIMA

Guests: Sebastian Mallaby

Interlude: Scarlet Buhagiar, AIMA


Tom Kehoe, AIMA  00:09

This week's episode is a real treat for you and for us as The Long-Short sat down with a man who needs no introduction within the Alternative Investment Industry. Sebastian Mallaby is the Paul Volcker senior fellow for International Economics at the Council on Foreign Relations. He is also a multi award-winning author and journalist whose CV includes five books which traverse the finance industry, including the workings of Central Bank's financial markets, and the definitive history of the hedge fund business. More recently, he has turned his attention to the venture capital industry. In his new book, The Power Law, details the rise of the venture capital industry, and its role in finance and business today.

Drew Nicol, AIMA  00:42

Sebastian describes the lengthy process behind his books, which anyone familiar with his work will know is always brimming with incredible details and peppered with the sort of behind-the-scenes anecdotes from industry legends, that few would know without his efforts.

Tom Kehoe, AIMA  00:57

We asked him what his thoughts on the hedge fund industry are, 12 years after publishing the award-winning More Money than God, arguably the definitive history of the modern hedge fund industry.

Drew Nicol, AIMA  01:04

I'm also very happy to report that we may have secured something of a scoop for The Long-Short, by getting a sneak preview into what his next book might be about. So, sit back and enjoy our conversation with Sebastian Mallaby.

Tom Kehoe, AIMA  01:18

Sebastian Mallaby, you are very welcome to The Long-Short.

Sebastian Mallaby  01:21

It's great to be here.

Drew Nicol, AIMA  01:23

So, Sebastian, you've written five books now each exploring a different slice of financial markets, and your latest book focuses on venture capital (VC). What was it about the VC world that caught your interest?

Sebastian Mallaby  01:38

There were two things I was trying to do with this book. One is simply to explain the thought process that goes into capital allocation with venture capital. It's such a different field, to any other sort of investment, because there are no quantitative metrics that you would find in public markets. Even in big companies, you can't do the price-earnings ratio, because a startup company has no earnings. You can't do book-to-value, because there's no book value in a startup, there's just, you know, a couple of people who walk into your office with a dream. And so, you know, all investment is a tricky bet, on an uncertain future. But venture capital struck me as especially uncertain because of this lack of quantitative benchmarks. I wanted to try to elucidate how that's even possible to do.

The second thing was the social impact and the impact on growth. When I began my research, there were people who told me that Silicon Valley was really Stanford valley that, you know, the success in innovation over the period from circa 1972, now was because of Stanford's dominance, and the ideas that came out of Stanford. There was another theory that it was all about defence contracts in the early days, they got things started. But as I looked at those theories, they didn't really stack up. For one thing, Stanford was a lot weaker than MIT, back in the 60s, 70s, and 80s. And in terms of defence contracts, actually more went to Boston than to the west coast. So, I didn't believe the standard theories. And I had this hunch, which I think my book has substantiated, that actually, venture capital, which creates the perfect climate for lots of people to try lots of startups and iterate the experiments until you get a hit, that is the way to do applied science. So those are my two goals.

Tom Kehoe, AIMA  03:37

And Sebastian, the Power Law is yet another a superlative piece of work that you've done, and congratulations on that, can you give us a sense for our listeners of the journey that you spent when researching and writing the book?

Sebastian Mallaby  03:54

Sure, all of these projects take me a long time, you know, four or five years, roughly speaking. And that's partly because I'm trying to really get close to the key success stories in the sector. So, with hedge funds, you know, I wasn't going to publish a book until I physically sat down a couple of times, with people like, you know, Stan Druckenmiller, Paul Tudor Jones, and George Soros and all of the other people I was writing about. And equally, with the Power Law, I wanted to, you know, spend a lot of time with the key partnerships, you know, Sequoia, Kleiner Perkins, Andreessen Horowitz, and it takes time to win access. You have to get to know the people who can introduce you to the other people who will then introduce you to the real people, and so that's why this takes a long time.

There's also a journey of understanding because initially, you hear a lot of things and some of them make sense, and some of them don't quite make sense. You have an initial set of questions, which probably a year or two later are going to seem naive, and beside the point. And in the case of venture capital, the thing I had to get past was this habit in Silicon Valley of offering cute, serendipitous stories about how big investments took place. So, if you asked for the origin story of, you know, Stripe, which is, I think, probably the biggest private tech company right now, a huge payments empire started by Patrick and John Collison, two Irish brothers, who moved to the US and started this company when they were incredibly young. You know, the stories I had, both from Patrick and John, and from Michael Moritz of Sequoia were lovely stories, but you kind of think, well, there's got to be more to it than that.

So, Patrick told me, for example, that he went to see Michael Moritz at Sequoia. And when he came out of the building, and Michael was chatting with him on the threshold, Michael noticed Patrick's bicycle, which was locked up against the perimeter gate. And so, he could see that Patrick was riding a sleek, Cervello road bike, and Michael being a cyclist himself kind of latched on. And they had this conversation about what was your speed on a certain famous climb in the Silicon Valley area, and when Patrick had a good time, that showed he was a gritty customer, and therefore may be a good startup founder. That was kind of how they clicked.

Well, maybe. But is that really how you allocate capital and spur innovation, it's about chatter about bicycles, there's got to be more than that, right? And so, to get past those cute stories, and really understand the thought process in a deeper way of how you allocate capital and all that uncertainty that I was describing before, you know that that took a while. And eventually, with Sequoia, I was able to spend a long time with the leaders of the partnership. And I think I got a pretty deep understanding of how they use things like behavioural science, to sharpen their decision-making process, how they really use teamwork within their partnership so that you get all the skills of all the partners at the disposal of the portfolio company to try to maximize its chances of success. So, there are a bunch of things that Sequoia does, which I think really do explain the Alpha. But the initial story was cute, but not really informative.

Drew Nicol, AIMA  07:45

It's so interesting, you say that, because what struck me in all your writings, really is that incredible attention to detail. And the anecdotes are fun, as you say, but just really providing insights into industries that are otherwise quite opaque. And I think the Power Law, similar to More Money than God and other books, could be seen as sort of a definitive history, in this case of the American venture capital industry and how that's developed. I really should say, probably is a must-read for anyone looking to get into the space or looking to learn more about it. But for anyone who hasn't got to it yet, could we just take a step back and could you explain what you mean by the power law and how that relates to venture capital?

Sebastian Mallaby  08:32

I think the easiest way to get across the meaning of the power law is to start by what it isn't. In statistics, we’re pretty familiar with the bell curve distribution, that's the normal distribution, where most of the observations in a dataset cluster are around the average. So right in the middle of the curve, you get kind of peaks at the top, and then it tapers off towards the sides. And so, an example of that sort of distribution would be the height of American men, the average American man is five foot 10 inches tall, and that's the most common also, so it's the middle height, as well as the average. Nearly all-American men are within three inches of that average. And so, it's a pretty fat top of the bell curve, most of the observations are clustered in that area. And somebody who's like way off the average, who is an NBA star, maybe seven feet tall, is extremely rare. And therefore, almost you can discount that kind of size of person because it's so unusual if you're thinking about, you know, what the average is. So, if there's a cinema, and there's 100 men in the cinema, and there's an NBA star of the back, and he's bored of the film, and he walks out halfway through it, that seven-footer leaving doesn't change the height of the residual man by more than a fraction of an inch.

On the other hand, there are some distributions in life where there's a few examples that account for all of the number. So, you know, 80% of the people might live in 20% of the cities, 80% of the peas might come from 20% of the pea plants. And if you think about not the height of American men, but the wealth of American men, and you think about that cinema, and at the back, instead of the NBA star, you've got Jeff Bezos, and he gets bored, and he walks out halfway through the average of the residual man in the movie theatre, the average wealth is going to plummet, just by one person leaving because this is a distribution with extreme outcomes. And venture investing is like that. It's not like normal stock market investing where it's very rare to get, you know, a position that moves by more than a few percent in a day. This is something where many of your bets will go to zero. And a small minority will do 1,000%, 10x your original money, or more than that. And so, all of the returns in a venture portfolio tend to come from this small tail of extremely successful bets. It's just a very different distribution to what you see in the rest of finance.

Tom Kehoe, AIMA  11:39

The book captures a lot of these stories, and you certainly get a sense of the amount of time and effort and thought that goes into all of the conversations that you mentioned in the various transactions or would be transactions that might have taken place. The power law function, then would push the protagonist, as you say, into making the outlandish bet. And you've alluded to it, but could you give us a sense as to how long the VCs would spend on projects that ultimately failed? Or, you know, as you say, how many investments would succeed versus that would fail?

Sebastian Mallaby  12:19

Yeah, the number that succeed is pretty low. I mean, first of all, a venture investor will be seeing lots and lots of pitches from startups, and only investing in a small fraction of them. So right there, they've screened out, you know, probably 98%, of what they see, they're investing in the 2%. And of that elite, in fact, a typical outcome, if you made 10 investments, might be that sort of five, or six or seven, pretty much go to zero, you get no money back at all. One or two might go sideways, and kind of return your money or a tiny bit more, but nothing much. And then one or two will hit it out of the park if you're being successful. And therefore, you know, make more than 10x, which in a portfolio of 10 bets, if they’re equally sized, one bet like that of 10x return will make back the entire fund. The second one will double the value of the fund. So that's roughly the math involved.

Drew Nicol, AIMA  13:31

So just to make this real for our listeners, do you have a favourite case study that you came across, that you'd like to share with our listeners?

Sebastian Mallaby  13:40

There are lots of great case studies in my book, in a way my book is, it's a history of venture investing, but you could think of it as a series of colourful case studies strung together to tell that history. And so, whether it's, you know, Fairchild Semiconductor right at the beginning of the story, or Intel or Apple, or Genentech, the first biotech company, or, Cisco, or Netscape, or you know, all these companies, that go through the history, but I guess, one fun one to think about is Facebook. Where Accel, one of the storied venture partnerships in Silicon Valley, won the battle to get to invest in Facebook, people kind of knew, just based on the early metrics, how quickly it was going to spread. On the very first campuses where Facebook rolled out its product, the uptake was extraordinarily fast. So, you can see this exponential growth and a lot of investors were excited, and Facebook ultimately went with Accel and that was partly because Accel had excellent teamwork.

Within the partnership, there was a young, Harvard, Stanford student who was sort of on campus and he was getting a retainer from Accel just to pass along tips about what students were interested in and what might be the next big thing. He alerted one of the younger partners at Accel, Kevin Efrusy, that this could be an investment worth looking at. Kevin did the research to sort of look at the metrics, and how fast was it growing, and when he finally got a chance to go and see the Facebook founders, he brought along with him, the founder of Accel, Arthur Patterson, who was kind of around 60 years old at the time. So, you have the young partner and the old partner going together and making a joint judgment on how compelling the investment opportunity looked. And then once they decided it really was very compelling, and they definitely wanted to do it, it took yet another partner to actually close the deal. It was somebody who had a great connection with another investor, Donald Graham from The Washington Post Company, who was sort of in line to invest and they had to kind of edge him out, and that was a delicate diplomatic process. And so that required the skills of yet another investor. So, you have this teamwork inside the partnership, which is in contrast to some sort of famous, but actually, in the end, less successful venture partnerships like Kleiner Perkins, where the lack of teamwork internally meant that everybody was just sort of stabbing each other in the back. And ultimately, that's not the way you win. It's a team sport.

Tom Kehoe, AIMA  16:36

I love how you recalled the meeting that Mark Zuckerberg had, where he turned up late and he turned up with some pyjamas. And he presented something which was not about Facebook at all, I mean, just the temerity to do something like that, knowing that you have the power, so to speak. Just fascinating.

Sebastian Mallaby  16:58

Yeah, that's right. He was really just mocking the venture capitalist that he was talking to. In this case, it was Sequoia, the top firm in Silicon Valley, but Sean Parker, who was Mark Zuckerberg's sort of business partner and kind of senior advisor, I think, you know, Mark was probably 19 and Shawn was perhaps 25 or something. Sean Parker had been fired from his previous startup by Sequoia and so he was just out to exact sweet revenge by having Mark go along and you know, arrive late, wearing flip flops and pyjamas presenting not about Facebook, but about a side hustle called Wild Hog that nobody wanted to invest in and presenting a slide deck which was 10 reasons why you should not back us. I think reason number two or something was because Sean Parker was involved. So, they were just taking the mickey and that's what partly gave Accel, one of the rival VCs, the chance to push its way in and get the deal.

Tom Kehoe, AIMA  18:11

It is fascinating. Sebastian, when writing, what particularly surprised you about the VC industry? When when you researched for the book, what was the biggest surprise?

Sebastian Mallaby  18:21

The biggest surprise came when I went to China. I had figured out by the time that I committed to writing the book that there was a good, persuasive, stronger story to be told that the reason for Applied Science flourishing in Silicon Valley was because of venture capital. Venture capital created a climate where money ideas and people could circulate quickly in the ecosystem, forming the sort of coalitions of teams that created startups. And then if a startup didn't work, it would fail quickly. And those people would be recycled into some other experiment. And that's the best way to do startups and commercial tech. So, I understood that about Silicon Valley, but I wasn't expecting to find the same in China because I thought, you know, it's a very different model of capitalism. The government has a lot of control in sort of directing where investment goes and nurturing strategic businesses. And it was only when I actually went to China and tracked down the origin story of all the famous early internet companies, whether it's Alibaba or Tencent, Baidu, Sina, and so on. All of these early Chinese internet startups actually had American-style venture capital.

Silicon Valley lawyers incorporated these companies with dispute settlement under New York law with an aspiration to go public in the US on the NASDAQ and structured importantly in a way that enabled Alibaba, for example, to give employee stock options to the early people that hired and that really opened up the possibility of hiring terrific people, because you could give them terrific upside. And, you know, it was the biggest, the most successful venture capital company in China, Sequoia, which is the most successful in Silicon Valley. So, the people and the companies are the same, the people have the same approach. And it's really a kind of second proof that this venture playbook creates innovation.

Drew Nicol, AIMA  20:42

I just want to go back to the Facebook example, because what's so interesting there is that it seems like quite a significant outlier in the power dynamic that you mentioned. And in that story of Mark Zuckerberg, because very often, if I understand it correctly, the dynamic is the reverse in that the VC funds will often have very strict screening process. And I think you alluded to that, and the firms seeking funding will be the ones that have to sort of play ball. And a lot of the time these firms won't get funding. Were there any stories you came across of firms that maybe failed first time around to secure VC funding, but ultimately went on to become very successful?

Sebastian Mallaby  21:30

Yeah. if you take PayPal, for example, they pitched the idea of money that you could email to, you know, dozens of venture capitalists, and were turned down. Eventually, they got money from a sturdy offbeat funder, which was the sort of venture arm of Nokia, the Scandinavian phone company. And it just so happened that Nokia ventures had somebody who understood a lot about cryptography. And PayPal's selling point was really that it had such good cryptography that you could encrypt money and safely send it over email. And Max Levchin, one of the founders, alongside Peter Thiel was himself a deep kind of crypto person. Crypto in the sense of cryptography, not in terms of tokens. And so, Nokia invested, but they had been turned down by tons of people. And then they went on, of course, to be a very successful company and a great financial expert.

Tom Kehoe, AIMA  22:34

Sebastian, the book mainly focuses on Silicon Valley’s VC landscape. And you've mentioned obviously, the chapter on China as well, it doesn't really go into a huge amount of detail on the European landscape. So, from your research, do you have any observations about the VC landscape in Europe today?

Sebastian Mallaby  23:00

Yeah, I'm very bullish on Europe. Although I didn't, you're right, include it in my book, mostly for space reasons. But the reason I'm bullish is that I think, you know, one can tell a story that up to about 2005. The way you did west coast venture capital was a bit of a secret. And Silicon Valley stood out from the rest of the world because it had almost a monopoly on this kind of extremely risk-friendly venture investing that was willing to back ideas that didn't really have a proper team yet, but the VC would invest anyway, and then help to form the team by helping to recruit the people needed. And so that model was different to let's say, the venture capital model that existed in Boston or New York, just more forward-leaning, more risk-friendly. And then in 2005, Sequoia and a bunch of other California companies went into China, and then in 2006, they went into India, and Southeast Asia. And meanwhile, there's been a spread into Europe a bit later than China and Southeast Asia perhaps, but still, it's coming.

Sequoia has an office now in London Index Ventures, which is a kind of continental venture company. It has operations both in California and in Europe. Accel has an office in London, very successful. Atomico is a great European VC based in London, founded by Niklas Zennström, who was the founder of Skype, and he understood the California model because r as a Skype founder, he had to receive capital from American venture investors, so he kind of got how it worked. And so basically, you now have in Europe and particularly in London, a very sophisticated group of venture investors who know exactly how the power law works exactly how you helped to build the teams of the startups that you back. And they are partnering up with software engineers, of whom there are many excellent people in Europe. In fact, there are more software engineers in Europe than there are in the United States. And the blockage in the past had been, you know, Europe didn't have the culture, that failing was a learning experience, they just thought failure was failure. And so, software engineers would stay at big companies, because it was too risky to go to a startup. But with this new type of venture capital available now in Europe, it means that you can raise money easily, and if you fail, you get a second chance. It has sort of de-risked the decision to be an entrepreneur, and not completely, entrepreneurship is always risky, but it's made it much less risky than it would be without the VCs. And I think, therefore, that Europe, which has always had a sophisticated group of software people, a sophisticated market of consumers, and great universities, what it was missing is a risk-friendly VC and now it's got that.

Scarlet Buhagiar, AIMA 26:35

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Drew Nicol, AIMA  27:22

I just want to change tack slightly, because as we mentioned at the top, this is not your first book on alternative investments. And the one that I wanted to bring up was More Money than God, which focuses in a similar fashion but on the hedge fund industry. So, just first of all, did you find any parallels between the types of personalities that ended up in VC versus hedge fund principles?

Sebastian Mallaby  27:49

I think there's an interesting contrast between hedge fund personalities and venture capital personalities. Just to simplify it a little bit, if you'll allow me. You know, a venture capitalist has to be a connector, an extrovert sort of schmoozer. And, you know, you could describe the job of a venture capitalist as being, get up in the morning, have breakfast with one person then have 14 cups of coffee with different people. Hopefully, the coffee is decaffeinated before they go to bed, right because they're trying to find the next deal they might invest in. They are trying to find the five engineers that could be hired by the person that they invested in last month. They're super connectors, that's what they do.

Hedge funds are a very different thing. You can invest in a bond or equity without actually meeting the bond or equity. It's not a person, you don't have to schmooze it, you just tell your broker to execute the trade. So, you can be an analytical person, you know, hidden behind a bunch of screens, and rather insular and not really be schmoozing. And that will work fine, and it might even be slightly an advantage. You don't want to tell other investors what your positions are because you don't want a crowded trade in many cases. And so, when Louis Bacon, one of the macro investors I wrote about in More Money than God, you know, did really well and bought himself a private island, people joked that it made no difference because he was so insular anyway. And as I said, that's a bit of a contrast between the introverts and the extroverts.

Tom Kehoe, AIMA  29:32

Sebastian despite the efforts of yourself and what we do at AIMA, and others across the industry, you know, many people still see hedge funds, and you alluded to it with the example you've just given. Hedge funds and more specifically, I guess short sellers, has been the villains in financial markets. We had the events of GameStop earlier in the year, and since then, they seem to carry more weight than ever with Wirecard, or Enron, so I put it to you then. What should the hedge fund industry be doing? And how can they ultimately change negative perceptions about them? Or is it just a fact of life that there's always going to be some form of negative perception about hedge funds?

Sebastian Mallaby  30:21

While like you, I've been around this debate for quite a lot of years, and I've come to the view that it's just really, really hard to shift the perception that there's something evil about short selling, or there's something evil about hedge funds. I mean, maybe it would help to just try to drop the name hedge funds and talk about investment firms. Perhaps there's less of a stigma there that it would kind of open people's eyes to the fact that, you know, hedge fund people are really just investors, just like, retail traders are investors. And so it's a bit rich, when people on Wall Street bets, and these Reddit groups, you know, who are groups of return investors, who are perfectly happy by the way to go short stuff. And in fact, RobinHood, one of the attractions is you can do leverage, and you can go short and all that stuff. And so, they're being hypocritical when they say, hedge fund people shouldn't go short because they do it themselves. But how do you shift the perception?

I know from personal experience, that when I write a piece in The Washington Post, where I sometimes do newspaper columns, and in the case of GameStop, I did defend the short sellers in the hedge fund space and say, it was absurd that they were being attacked by these hypocritical Reddit people. The deluge of hate mail I got extended to people actually making YouTube videos, calling me out as a moron. I mean, it's really, really hard to shift the perception. I don't know what to say on how to fix it.

Drew Nicol, AIMA  31:57

I was covering GameStop when it first happened as a journalist in my former life, and I did notice the same thing that any tweet, any coverage just got, I guess, picked up by some sort of algorithm that then ended up on a Reddit site. And it was incredible, the backlash and the scale of it. Regardless of what you were covering, unless you were firmly in the Gamestop Reddit camp, it was very one-sided. Just on that theme, since you brought out your books, we've also seen Hollywood has had a go at depicting hedge funds. And we've had obviously had The Big Short being there, the main one that people might know, also Margin Call, and then there's been TV series like Billions. And in the UK, the BBCs. Industry - season two at least has some hedge fund people appear. And as always, they seem to turn up as these larger-than-life characters living these lives of excess. And, you know, we spoke about private islands before and maybe there is some truth there. But do you feel that the Hollywood productions get it right, are they fair to the hedge fund industry?

Sebastian Mallaby  33:19

I mean, I think portraying successful hedge fund investors, as people living, you know, plutocratic lives probably involving a bit of excess. I suspect that's fair. I mean, I called my book 'More Money than God', you know, for a reason that people do make extraordinary amounts of money when they succeed. I happen to think that the investment process they go through is good for the health of financial markets and for intelligent capital allocation. So I'm not bothered by the fact that people get very rich as a result. I think maybe, you know, we could debate what the right level of income taxes is, but the fact that people get rich doesn't bother me. If TV series have fun portraying that wealth. I don't think that's wrong.

I think the one thing I would say about The Big Short, which was a great movie, and I'm sure people listening may have watched it. The thing I think I slightly regretted about that story, is the way it was told us that it really goes down deep, I mean, doubles down on the idea that the people who shorted the subprime mortgage bubble, were these wacky kind of crazy people who had drumkits in their offices and, and so on. That reality is that the biggest short position was put on by John Paulson and I know John Paulson, I interviewed him for my book I interviewed Paula Pellegrini. Who was the analyst who did a lot of work developing the thesis for The Big Short, and these are pretty sort of sober, besotted analysts. They don't have drumkits in their offices. And I think it's sort of, you know, the drumkit thing is good TV, but it implies that you had to be kind of a wacky eccentric. And that's where the trade came from. No, the trade came in the case of Paulson and CO, from, you know, buying a ton of proprietary data about historical house price behaviour, investing in extra computer service, so that you could have all this data, and then hiring extra data analysts to make sense of all this data. And they did serious work, they spent millions of dollars on it, to come up with enough conviction to put a huge, huge, short position on that, to me, is a less sexy but more realistic representation of where the hedge fund conviction came for that trade.

Tom Kehoe, AIMA  36:18

And as you say, Sebastian, having the conviction to pursue that view as well. You know, when you have all sorts of naysayers, as well, you know, really challenging these positions we had earlier in the year we had Dan McCrum who wrote his book on short selling and Wirecard. And he relayed a very point back to us as well. Ray Dalio, you would have heard seen the news. Founder of Bridgewater, he's recently announced that he stepped down from his role as the co-chair. So that's effectively then ceded control of Bridgewater as part of their succession plan. Having written More Money than God, what is it now, 12 years since that's been published, and you would have written in intimate detail about the various personalities that underpinned the modern hedge fund industry. And it seems like Ray Dalio is certainly part of that era. So how important then do you believe succession planning is for the continued development of the hedge fund business?

Sebastian Mallaby  37:38

You know, the traditional answer would have been, it's not important at all, because the way the hedge fund industry does work and should work is sort of more Darwinian than that. In other words, you get, you know, a great macro trader like Stan Druckenmiller, or Paul Tudor Jones, or Louis Bacon, you know, they have success, they build a company around them. But it's actually not a tragedy, if they get to a certain point, they don't want the hassle of running outside money, they retreat and just invest their own money for a while, and then ultimately, they retire. And then the position is sort of taken up by other trading firms that spring up to exploit the alpha that's been left on the table. And that feels like you don't need succession within the firm, it's fine for one firm to fade out and another to come in. And if you look at the way Julian Robertson closed down Tiger Management, and use the remaining assets to seed, other funds, including Tiger Global, that's a very good model. It's good for the LPs who are invested, they just shift their funds into a younger manager. And that can be very lucrative. It's good for the industry because it kind of creates this sort of, you know, constant rejuvenation.

I think the wrinkle and why the answer has changed a little bit is that you know, there are now these big hedge funds that have become franchises and Bridgewater is one of them. And so, Ray Dalio in retiring is bequeathing a going concern, which as a big brand, a lot of assets under management, a lot of credibility with allocators. And so, that is a handover not a fade out. And it's even more true of companies that are more explicitly sort of quantitative. I mean, Bridgewater, I think of as being a kind of hybrid. There is a lot of data-driven research. I think a big accumulation of knowledge within Bridgewater as generations of analysts have looked carefully at different details of the way the global financial system works and each time they do a research project, it kind of gets added to the database. And so, knowledge is being built up. And that's why there is something to hand on. It's not just a sort of intuitive individual who looks at markets and makes, you know, real-time decisions. It's a system. And that's why (Ray) Dalio can retire, and somebody else can take over. But for systematic hedge funds, like Two Sigma, it's even more true. And when computers are doing the trading, the computer scientists that built them can retire, and it's fine. So, I think succession planning is important.

Drew Nicol, AIMA  40:37

We've mentioned a few of the biggest names in the industry so far during this conversation, and something that stuck out to me is that although they're undoubtedly, you know, some of the sharpest minds, in financial markets today or, you know, as they were growing, these firms that are now household names, there does seem to be a common thread that they were also presented with opportunities in the form of being the first to develop new strategies or take advantage of major macro-economic trends of their time. And I just wanted to ask you, whether you think we are still in a place where newcomers to the industry or those looking to reinvent themselves are able to do the same because financial markets are a lot more sophisticated. Now, many strategies that were once niche, I would say, are now quite crowded. And it would be interesting to hear whether, you know, the big names of George Soros, Jim Simons, even Alfred Winslow Jones, could they be as successful as they were then, today?

Sebastian Mallaby  41:48

Financial markets are not static, they're always evolving, and there's going to be a new frontier, the frontier might be geographic, it could be that, you know, you get enough depth in African stock markets over the next, you know, 10/15 years, that there is an opportunity there to trade them in a way that you can't today. I mean, you can do stuff today at the margins, but it's not a super-rich environment for hedge funds. So that's one kind of (potential) frontier.

There's also new financial instruments that get invented, new kinds of data that become available, you can apply increasingly sophisticated algorithms to that data to get trading signals. So, you know, the application of artificial intelligence is already going on. One assumes that if quantum computing realises the potential that some people see in it, quantum trading will be a big deal. So, I very much think that there are always new frontiers to be conquered.

Tom Kehoe, AIMA  42:57

And Sebastian, one area that has seen a real frenzy of activity and continues to fascinate, and indeed fascinate us is the emergence of digital assets. And we've even heard some comparisons being drawn to the emergence of digital assets and that of hedge funds in the modern age back in the 1990s. What's your take on digital assets?

Sebastian Mallaby  43:22

I'm very intrigued by digital assets, I've actually spent part of the last sort of six or eight months since my book came out, thinking about whether I should write a book about digital assets, and going off and speaking to people who invest in this space. And I mean, I love the stories, it's just incredible how individuals have been able to do projects on Ethereum, that have become enormous. And it's just the work of one, one or two people. You think about something like Uniswap, which allows you to switch between different crypto assets created by one young engineer who had just been laid off from Siemens, and he was kind of doing a hobby and all of a sudden, it's this incredibly big thing, which is worth, you know, multiple billions of dollars. And by the way, after the correction is still worth well over a billion dollars. So, the stories are amazing, the kinds of claims made on behalf of crypto in terms of how it might change the world. Intellectually fascinating.

But what I've learned is that in any conversation I have with a crypto investor, there'll be a question I asked, you know, 20 minutes in or something and the answer will be a pause, followed by “it's super early”. That means we don't know the answer. This is all evolving. We're kind of making it up as we go along. And I think that's right. And although there are certain things in Defi, for example, where you can borrow, you can trade and all these things. decentralized protocols with smart contracts that make that possible, you know, are just amazing. As pieces of infrastructure, there is the kind of bigger question when you step back, which is, why do we actually need tokens? I mean, it's great, we can trade them, and it's fun for speculation. And, you know, that's all good. But it's ultimately the dollar, which you need if you're going to pay taxes, and you probably need if you're going to pay for, like tons of other stuff you want in the real world. And crypto assets haven't solved that problem of crossing the chasm. If you ask somebody who is fundamentally not interested in crypto, why they're going to have to use it, just like you really have to have a smartphone these days, or you couldn't really get by without a computer. Crypto is not there yet. And I think it's interesting, I believe it will get there, by the way, I just don't know which bits of it will get there. So, I think it's a very speculative area.

Tom Kehoe, AIMA  46:07

Very interesting.

Drew Nicol, AIMA  46:08

Well, to me that sounds like the beginning of a thesis. From your work so far, what I've appreciated personally is your even-handedness when it comes to these topics that as we mentioned before, often get a bit of grilling on the Reddit forums or sensationalised in Hollywood, so I'd look forward to anything you put out on the digital asset space. And you preempted my last question, actually, which was just to ask you what you're working on now. But I guess all that’s left is just to say, you know, as someone who is always looking out for a guide, or a history lesson on the Alternative Investment Industry, I was very keen to speak to you today to really get an idea of the process that goes on. I mentioned before the incredible detail that you get in your stories. So, thank you very much for your time today on The Long-Short and for indulging us.

Sebastian Mallaby  46:57

It's been really a pleasure. Great to be with you.

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