Wall Street Unplugged
Episode: 896May 19, 2022

How the Fed can control inflation

Joe Zhao

Joe Zhao, former Fed economist and founder of venture fund Millennia Capital, shares an inside view of the Fed’s policymaking process and the private equity market.

We discuss what the Fed should do to control inflation… Joe’s take on SPACs… how a successful private equity fund approaches opportunities in the private market… how the government will regulate crypto… and why it’s time to buy IPOs.

Inside this episode:
  • How the Fed can slow inflation [0:19]
  • The psychology behind successful investing [12:58]
  • How a successful private equity fund decides what to buy [18:32]
  • The main goal of both venture capitalists and SPACs [26:57]
  • How the government will regulate crypto [32:15]
  • Why it’s time to starting buying IPOs [40:27]
Transcript

Wall Street Unplugged | 896

How the Fed can control inflation

Announcer: Wall Street Unplugged looks beyond the regular headlines heard on mainstream financial media to bring you unscripted interviews and breaking commentary direct from Wall Street right to you on main street.

Frank Curzio: What’s going on out there? It’s Thursday, May 19th. I’m Frank Curzio, host of the Wall Street Unplugged podcast, where I break down the headlines and tell you what’s really moving these markets. It’s a great interview today. The former Fed economist, Joe Zhao, worked at the Federal Bank of New York, helped out on Bernanke’s taper tantrum plan. He’s no longer at the Fed, left to launch his own venture fund called Millennia Capital, which he invested in some of the big tech unicorns in the pre-IPO rounds.

Frank Curzio: But a Fed economist starting a venture fund, it’s rare. Something that you don’t see. The Fed is usually big macro and venture is more small and looking at ideas, so Joe is a super smart guy. I was introduced to him from John Petrides, and we spent 40 minutes on the phone just talking. I said, you know what? I got to get this on interview. It’s fantastic because it’s about PE, which is private equity, venture funds, valuations, how they’re changing.

Frank Curzio: And also, he had a lot to say about the Fed and how they’re addressing policy right now. And, yeah, it was just so amazing, I said, “Listen, I got to get you on a podcast. It’s going to be a fantastic interview.” It’s so relevant today with the Fed, and a lot of people believe the Fed has lost his credibility, don’t know what they’re doing, but let’s hear from Joe what he has to say, he still has great context throughout the industry.

Frank Curzio: And again, the PE investment point, and we’re not hearing about that reset in that part of the market. We’re seeing the reset every place else but the private market, where valuations, where they were determined by capital raises well below those valuations. So, let’s hear about them now, hear about those opportunities that he’s seeing from someone who is tied into the Fed and tied in to the private equity and venture markets. Great interview coming up, guys. You know what? Let’s get to it right now.

Frank Curzio: Joe, thanks so much for joining us on Wall Street Unplugged.

Joe Zhao: Well, thanks, Frank. Thanks for having me.

Frank Curzio: So, first-time guest, this is awesome. Man, I have so many questions. And John Petrides introduced us, and we were on the phone for a while just talking and discussing things, really cool, but I want to get to the Fed. It’s common for everybody to destroy the Fed all the time, the Fed’s terrible, terrible, terrible. And I think we would all agree, very late to the party in terms of addressing inflation. You’re someone who is at Commerce there, someone who worked there. What do you think about what’s going on and how can we correct this?

Frank Curzio: Are they still going to be behind the curve? Let’s go there, because there’s so many further questions I have, but just from an insider’s point of view, as someone that worked there, are you surprised by the reaction that it was this late to really start raising rates, shrinking the balance sheet, and regardless if we want to talk about how bad a decision it was late, to be late to the party, what’s the plan now? What’s the plan for the future? And is this going to work? Are we’re going to see more pain ahead? Just what are your thoughts?

Joe Zhao: Well, thanks guys. Well, just a quick background, so I worked as a policy economist at the Board in DC in the monetary policy division for a few years in the 2010s. And then, I left that side of the world and went to business school and did my things in consulting and banking. And now, I run my own venture fund focused on technology and venture. But obviously, private markets reacts to that policy, so I still very closely follow what’s going on the macro world. And because I worked on both the monetary policy and the financial market side of things, the transmission mechanisms, that’s what they call it, I just have a couple of viewpoints on what’s going on with that. I try to marry what’s going on between not only the private markets and technology and tech sector and public markets, equity markets, but also what’s going on from a macro perspective.

Joe Zhao: So, it’s a very interesting time right now because what’s happening today as we speak, and today the markets are down a lot, is the reversal of what happened 10 years ago, 11 years ago when I was there. So, let’s think about what happened then. So, what happened then was ’09 we had a bottom, they came in with QE, they lower rates, they inject a lot of liquidity into the marketplace. And that basically rebooted the financial system. Now, for the reverse where there’s too much liquidity, one can argue there’s too much capital and the rates are so low, there’s still QE. So, what we’re trying to do is to backpedal from that policy. And so, what we’re seeing today is the reversal of what happened 10 years ago, where 10 years ago we have rates going down, capital going to the rest of the markets.

Joe Zhao: So, aka equity markets, some of the riskier part of the assets across the spectrum, now it’s reversed, where they’re raising policy and withdrawing liquidity. And so, capital are flowing back into the riskless part of the spectrum of the assets, namely treasuries, MBS, CDs, and away from the equities, some of the high risk assets, prime equity venture, and blockchain and crypto. So, you can also look at what happened 10 years ago and what happened now through a mirror image of one another.

Joe Zhao: Now, with respect to whether the policies were on point, honestly, it’s very hard to forecast what’s going on. If you’re the Fed, it’s very difficult to forecast the peak and the trough in markets, because just like in private markets, in the private sector, it’s almost impossible for hedge funds and institutional investors to time the market. For the Fed, to time the market is also very, very challenging.

Joe Zhao: So, but the Fed really has two mandates. Max employment and priceability, and those are interchangeable. Sometimes one is one, sometimes one is the other. So, what happened was last year, I think with Omicron, they just wanted to keep the gas on the pedal a little bit longer and hopefully get the unemployment rate a little bit lower. And inflation, they thought was transitory, which I think in the perfect macroeconomic model, and most economists at the Fed, a majority of them, are academic economists, things happen in a perfect way, like the models that we used to study in grad school and undergrad. But in reality, there’s always the exogenous factors. So, I think the external factors that happened last year were Omicron, that was unforeseen, the supply chain issues that were unforeseen, and now the war, that were unforeseen.

Joe Zhao: So, a lot of those factors that were beyond the Fed’s guesses contributed to a type of supply. And so, with aggregate demand being so high, that’s where you’re seeing the inflation being so high right now. So, looking at what’s ahead, I think inflation has to come down first. And right now, you can argue that between maximum employment and priceability, prices are so high and employment is actually at a point where it’s actually over maximum employment, because there’s two for one for every job opening. So right now, you can almost argue that the Fed has overachieved its employment objective, and underachieved on its price stability objective. Now it has to go reversal to kind of get those two back to mutual states.

Joe Zhao: And so, we’re right now entering that process. And financial markets is obviously where I work and where lot of your listeners here work in. So, unfortunately the thing I have to mention about financial markets is financial markets have never been a core objective for the Fed’s policy objectives, because usually, from 100 years ago when the Fed was founded, 1913, maximum employment and priceability were always one and two objectives, priorities, interchangeably, depending on the circumstances.

Joe Zhao: Financial markets were never historically a top two priority for the Fed. In ’08, financial markets, and the term they call it is financial stability, became a much more important objective for the Fed. So, it became a distant third, if you will, objective for the Fed. And that is why sometimes in the last 10 years, you hear the Fed speak and they talk about financial stability, smooth function of markets. And that was because 10 years ago, when the banks went down, markets weren’t functioning. And then so it was the financial markets that dragged down the overall economy in a way.

Joe Zhao: So, financial markets became a priority for the Fed, but it’s never one of the two objectives mandated by Congress. So, as a result the Fed, the indicators they look at tend to be labor market inflation, and then financial market indicators are a third priority if you will. And what’s happening today in the equity markets, fixed income markets, whether it’s financial conditions, are just components of the financial stability topic which they’ll visit at every meeting, but it’s never a core component of their decision making. And so sometimes, folks in the markets talk about, hey, the DOW is down 10%, 20% year to date, yields are up. Well, those are important, but again, what’s happening in the markets will never directly influence the Fed’s direct policy decision making.

Frank Curzio: Yeah. That makes sense. And you mentioned something that’s key here, is you said academic models. And I think that’s what we’re running into trouble because we’re looking at academic models, which we look at the past to try to dictate the future. And they say, well, if it rhymes, if it’s not perfect, but these are conditions we’ve never been in. $9 trillion in the balance sheet of the Fed. Whatever we want to put in perspective and inflation and return, however you want to put it, the amount of money that was injected. We never saw lockdowns before. We never had zero interest rate policies for pretty close to 10 years, outside of a little bit of a period where we raised in between that period, remember 2017, ’18, and just seeing the constant Fed purchasing, just bond buying.

Frank Curzio: We’ve never seen these conditions before. How do we change that? Because I just feel like the academic models, and I say this a lot and I don’t mean it in a bad way, but I say every investment book you ever read just turned to garbage. It’s really not going to help right now because these are conditions we’ve never seen before. We’re in no man’s land, where there has to be consequences. And I just felt like in 2008 the worst thing that happened, and I’m going to say, I thought Ben Bernanke did an unbelievable job. You recapitalize the banks, people don’t understand the whole entire system is broke, the commercial paper market was broken, you couldn’t pay employees, you saw money market accounts fall. And it was just terrible conditions, where he did a fantastic job, but I look at today and how different that is.

Frank Curzio: But the worst thing that happened then is when the Fed decided to capitalize the banks, that was great, but they made money on everything that they did. And they made a fortune on it, whether it was they took all the real estate, they invested, they had options, they had warrants in so many different companies. The housing market, they took all those assets on their balance sheet and they’re still in conservatorship, Fannie and Freddie. And I just always felt like that was a negative because the next scenario that we had, I just felt like they were going to go all in and they did. How do we change this to where we could try to figure this out? Because being a no man’s land and looking at academic models, to me, it spells disaster.

Frank Curzio: And you could argue whether it’s a disaster now or not. We had high valuations, but we do have inflation that the Fed is really, really having trouble controlling and eventually higher prices are going to cure higher prices, and we saw with Walmart and Target, people are definitely shrink and cutting back, but how do we get this better? Is there a system in place you think that we can get this better or we could become… We get it, forecasting is always a tough job. You do it. I do, we have to do it for our customers. It’s very, very difficult. And the Fed has a difficult job. I don’t want to trash the Fed here, but how do we try to get better? Because this wasn’t something that they were just like, “We made a mistake on,” they were miles away wrong. They were very, very wrong on this. And it seems like a lot of people are paying are paying the price right now.

Joe Zhao: Yeah. So, Alan Greenspan had a book, and I met him 10 years ago, but he had a book, we were at a signing, and the title of the book was The Map And The Territory. So, the map being the model of the territory being the landscape that you navigated. So, when you’re the Fed, you’re the government, you’re the quasi-government, you’re the central bank, you’re the map. It’s very hard to exactly dictate what’s going to happen because monetary policy is a very blunt tool. The rates literally impact every sector and global capital flow in so many ways. So, it’s not an easy job, but I would say every institution needs to become more innovative as the world changes, that’s the private sector of the government. So, are there ways for the Fed to become more innovative?

Joe Zhao: Absolutely. They were founded in 1913, and I do think there are ways that they can really improve their forecasting, their policy making. I’ll just give you a few examples. Some of the data points, some of the surveys that they’re doing right now are really surveys and data points that they’ve been gathering for the past 30 years. And the world’s changed a lot in the last 30 years. In 2020, in 2022, some of the fastest growing parts of the market, the economy, are technology, blockchain, crypto. But when you look at some of the releases by the Fed, if you look at some of their speech or some of the market indicators that they follow, things tend to look backward, not forward.

Joe Zhao: So, there are ways for monitoring the markets and the economy to adapt with time. And you can also argue, and this is something that I’ve wondered when I was working there, you look at these CPI data points, GDP numbers, all these data points that government tracks are produced by the federal government, the Commerce Department or Labor Department. And there were a lot of talks in DC that some of the data points that the Labor Department, the outliers we’re tracking were really just bad or not great data, or the formula were formulated 20 years ago. Obviously, the competition of the economy today is way different than 20 years ago. So, I do think that the quality of the data that they use to make policies can be upgraded over time.

Joe Zhao: But back to your point, it’s not an easy job to call bottom or top in the market. But I do think that there are things that we participants in the private market and public markets can do to do the best we can to position ourselves in the best way possible, so that no matter if they make a mistake or if they’re right, that we of leveraging the macro macroeconomic cycle in our favor rather than against us.

Frank Curzio: That makes sense. And one more question about the Fed before we get to the really fun stuff, people are going to like the private equity and venture stuff that you’re into, but I want to quote you, because you said, “Fed policy, transmission mechanism, easing financial conditions is not equal to tightening of financial conditions. In behavioral psychology, $3 gain equals $1 in loss. When asset prices rose in 2010 to 2019 businesses and consumers felt good. When asset prices will fall in this 2022 to 2023 tightening cycle, which asset class will be the first casualty?” And before we even get to the first asset class which will be the casualty, which we can go a lot of different places with that, but explain what that means because I thought that was a really interesting statement when you sent me that. I’m like, wow, yeah, just explain that.

Joe Zhao: Yeah. So, this is something that I actually wanted to talk about because I really hope that the viewers of your show can really just incorporate this, internalize this concept into their own decision making. So, basically in behavioral psychology, I think we’ve all had these happen to our lives where when you make a dollar and when you lose a dollar it doesn’t feel the same. So, in fact, risk aversion is how we operate as human beings. So, I think there are some studies I read that show that the ratio really is three to one, meaning if you made three million dollars last year, but somehow you lost one million dollars, and you netted two positive, it actually feels the same to you.

Joe Zhao: And that’s just how our psychology, we’re wired, and then by the same token, we’re extremely risk averse to losses. Gains and losses don’t feel the same. It’s a curve of a chart as you plot it. So, when you apply that psychological study to what’s happening in the market today, so 10 years ago, one of the things the Fed actually does a really good job of looking at is how policy transmits into the markets. So, how QE worked and how things worked 10 years ago was, so there’s really several channels by which monitor policy really impacts the market. So, let me go down one for one.

Joe Zhao: So, the first is when you lower rates 10 years ago, you’re making it less attractive to park your cash in CDs and fixed income, so that would force people, investors, to reallocate their capital away from the riskless part of the spectrum into the riskier part of the spectrum. So, folks went from CDs and fixed income to equities. And in the last 10 years, what we saw was rates were so low, we had this bull market for 10 years, a lot of capital went into the riskier part of the market, so namely equities, venture, blockchain, if you will. Well, now, you would think that now the rates go reverse, when rates are going up, that flow of capital would begin to outflow from the risky part of the spectrum and back into the riskless part of the spectrum.

Joe Zhao: So, namely if your CD rates are now 2%, well, if you can get 2% for certain versus you can lose or make money in the S&P. Well, you would obviously consider putting some of your cash in CDs, so that’s one channel. The second channel is when the Fed was buying a lot of treasuries and MBS, they were basically sucking a lot of the new supplies in the market. Well, then what that does is it crowded out a lot of the normal participants in fixed income into equities. So, again, now what’s happening is reversed, where now they’re not buying almost any MBS or treasuries anymore. They’re actually winding down those securities. Now, the normal fixed income players would go back into the fixed income market and capital would, again, fall back into fixed and away from equities and some of the private equity venture capital, blockchain, et cetera.

Joe Zhao: Number three is obviously foreign exchange and that’s just making it cheaper or less so to influence international trade. So, there’s a lot of these channels by which the Fed, not only do they monitor these things, because you can back out the indicators they look at from some of the speeches that they publish, but they do a good job of tracking how policy impacts mortgage markets, CD markets, auto financing, and the global capital flow. So, the thought that I had, which I’ve been thinking about is, the last 10 years people felt really, really good because everybody made a lot of money in equities. But now, when you have the reversal of that, if you think back to that one for three logic, if people lost a third of what they made in the last 10 years, that would make people feel as if nothing had happened, that would make people feel different.

Joe Zhao: If people lost 50% of what they made over the last 10 years, that means people are net negative, feeling awful. And if people lost 100% of what they made, that means it feels like you’ve lost three times the money that you made. And I’m concerned just about the cascading effect on people’s psychologies when they see their 401k accounts decrease in equities when the policy permeates throughout the rest of the markets over the next six to 12 months. So, it remains to be seen, but I would be very cautious about really balancing your portfolio to make sure that you hedge your bets so that, I don’t want to be the one that for example, loses 100% of what I made in the last 10 years and feel three times more awful, as if I never made it.

Frank Curzio: Sentiment’s a big thing. Thank you for explaining that. That was great by the way. But it’s such a big thing and you’re seeing it right now, a market that maybe you’re not really seeing it in the news. We’re seeing how a lot of these stocks are getting nailed, but you’re looking at the unicorns, you’re talking about SPACs getting killed, and a lot of the recent IPOs that came out with crazy stupid valuations.

Frank Curzio: But the private markets, some of these companies that haven’t come out yet, they’ve raised money. And when they raise money to just keep everyone involved, and I know this, when they raise money that determines the valuation, they just raised a hundred million dollars which values them at 5 billion or whatever. Talk about what’s going on in that market and sentiment, because what I’m seeing right now, and I know you’re seeing even more, but a lot of these companies that came in for the last couple capital raises, now we’re trading at levels that are below that.

Frank Curzio: But there’s other things that you talked about too within this. Well, let’s start there, and then we’ll get into the volatility of that market. But what are you seeing in this market? This is your market where companies are looking to raise further money, what about those investors that just came in, what’s the plan? Is it to build up the company even more before going public at a future date? But it’s very hard when you’re raising money in the private market side of evaluation, and then that valuation falls below that so fast. What does that mean for your market?

Joe Zhao: Yeah. So, I cover the venture market and venture growth equity, and so what’s happening today is a valuation reset because traditionally private markets follow public markets, we’re talking equity, with a six month lag. And that was true in a way, and that was true in the one. But what’s happening today is the transmission mechanism from public markets to private markets is happening quicker for a couple reasons. One, because a lot of the venture investors have become public market investors because their portfolio companies went public in the last 12 months. So, everybody has some sort of stock in the stock market. And two was just there’s been this whole rise of crossover funds, the Tiger Globals, the SoftBank and the like, where they invest at the pre-IPO stage and they’ll hold the share’s post-IPO.

Joe Zhao: So, obviously we’ve seen news like Tiger is down 40% year to date in their fund, and part of their portfolio is public, part is private. So, if you’re the one managing Tiger’s fund and you’re down 40% in your public, well, of course you’re going to make different decisions in your private portfolio. So, this time the transmission mechanism is quicker and that ties back to what we were talking about earlier, when policy changes, when rates go up, obviously valuations in public markets, especially tech, begin to correct. And traditionally there was a six month lag before public would hit private markets, but this time it’s been quicker. So, we’ve seen as early as December of last year, that some of the lead investment for polling term sheets, we’ve seen in January and February that some of the venture backed companies were beginning to freeze on hiring.

Joe Zhao: And obviously in the last couple of months, we’ve all read articles about some startups unable to raise capital and they’ve had to shut down. And it’s unfortunate because I’m a millennial, but I’m actually an old soul so I read a lot about what happened in the past 30, 40 years. I’ve also read studies that some of the millennials, some of the younger generations, have never managed money in a rising rate environment. Well, at least I try to read what happened in previous cycles. So, unfortunately a lot of the fund managers, even the founders themselves, I wish they have the same access and coverage by investment banks’ economist teams as some of the public companies do. Because in public companies, you’re covered by a bank, all these banks, at Goldman, JP Morgan, have economist desks that will send you research on what’s going on in the markets.

Joe Zhao: In private companies, that’s not so much the case. So, what we try to do with our position is we talk to our founders and we try to be the economists here. We try to figure out what’s the bold case, what’s the base case, and what’s the down case for where our economy can go. And we want to help our founders to budget and plan for the worst and obviously hope for the best. So, unfortunately what we’re seeing today, and there’s really three things that I think are happening. One is if you are a private company, but whether you’re a SaaS company, FinTech, even blockchain, whether you’re a marketplace, we’re talking e-commerce, cybersecurity, data companies and FinTech companies, payment companies, if you’re close to the IPO window, your private valuation is probably stale.

Joe Zhao: That doesn’t mean that your true value, your intrinsic value, is at that level. The way the private markets work is your private valuation doesn’t change. But your intrinsic value, if you run the DCFs on this company, is actually lower, but private companies can obviously choose to say private longer. So, they can try to grow into that valuation then maybe go public in 2025, when they’ve grown into the valuation and markets have gone the other way. And then, you would actually make your pre-equity investors some money. So, the private companies that are well capitalized, that have two, three, four years of cash runway should do just fine because over the next two to three years, our advice, our suggestion was try to cut down on burn, try to become cashflow profitable, and try to extend your cash runway for three to four years.

Joe Zhao: So, hopefully in three to four years, when you do decide to raise IPO capital, the markets have returned to normal conditions. Right now, we’re not in normal conditions. If you’re earlier stage, I think the same logic applies, but the second thing that I wanted to mention was there’s one category of private companies that I’m really, really concerned about. And that is the companies that raised their last private rounds at a significantly higher valuation than public market. I’ll give you an example. There was a company that shut down in New York called Fast Payments. It’s a payments company. Their revenue in 2021 was not even a million dollars, their last private round in 2021, Q3, Q4, was 500 million dollars. Now, that’s 500 times revenue. Public market peers like Payments, PayPal, and things like that, Square, trade historically, between the last five years averages, between five and 15 times revenue.

Joe Zhao: At the peak, they were trading at maybe 15, 20 times. Now, they’re trading back today at probably six times. Well, in last year’s bull market, you could raise that 500 times revenue, but in this market, you can’t raise at that level. No one will back you. So, this company had to shut its doors because they just couldn’t find a buyer, an investor, whether a PE buyer or strategic or a venture buyer that wanted to come in at even close that valuation to give capital to this company at that valuation level. So, basically the takeaway is if you’re a private company and your last round valuation was much more reasonable compared to public market peers’ both five-year averages in a conservative manner. And if you can cut down your burn, and if you need to raise, you should probably do fine. But the companies that were raised at such higher, unsustainable valuations might be in some trouble right now.

Joe Zhao: And then, the last thing is obviously in that logic, the closer a private company is to the IP window, the more it’s impacted by what’s going on in the public markets. So, by the same logic the further away you are from that spectrum, the more shielded you are. So, some of these seed and pre-seed and some of the Series A companies just haven’t seen as significant value from reset. And that’s for a couple reasons. One is because the seed and Series A companies, their IP windows, if they’re ever successful is five, 10 years out.

Joe Zhao: So, who knows what’s going to happen in 2030, we could be in another 2020 environment. We could be in a 2022 environment. The second thing is they also just require way less capital because a Series A company by definition is somewhere in between 50 to 100 million valuation. You raise 10 million, a lot of big funds have a lot of dry powder, they can deploy $10 million and that’s much easier than putting over a billion dollars and going into a private company. So, some of the early stage companies, we do find that’s where the innovation happens. Some of the growth stage companies, it really depends on your valuation. And some of the late stage companies, the overwhelming sentiment I’m getting is that they’re staying private longer to grow into their valuation so that when they do go public they don’t trade down, they actually trade up and make their pre-equity investors some money.

Frank Curzio: So, how does that work? Why did SPACs become so popular? One, okay, we could say because of the market conditions, there’s free money everywhere. But you saw the big funds pushing this because it’s the liquidity period. It’s when could you cash out? And it usually takes seven to 10 years with the strategy that you’re talking about right now, but now you have SPACs where you don’t have to disclose warrants and stuff like that, and yeah, you can come in and out of them, it’s just the rules are much different. But more importantly is you can get in and out of these things that are already publicly traded vehicles, just find a company, inflate the value, do your roadshow, whatever, we know the playbook. And a lot of these things are getting nailed now because some of these early investors that started these things are in very, very little.

Frank Curzio: They could sell these things, come out 10, 12, go into whatever, they could sell them at three, four and still make money. My point is with venture capitalists the goal is always to make as much money as quick time as possible I would think. And with this strategy, does this change that strategy to the point where, hey, you’re not going to be able to do that because you don’t want to come out with IPO today, I don’t care who you are.

Frank Curzio: But is that okay with a lot of these venture firms, where the people investing in them will probably just, especially over the past few years, hey, we’re getting into all these things and all these unicorns, they’re all coming, IPOs. What you’re telling me right now is, hey, these early stage companies, which is a great idea, it makes a lot of sense, but is that going to result in some of the venture capitals going, you’re still too far away though and how do we cash out? Where’s our liquidity period? Is it going to be too far down the line, where we’re going to have all this money locked up? Are you seeing that as a concern?

Joe Zhao: Yeah. So, private markets really have changed a lot in the last 10 or 15 years. The reason I became so interested in venture was because I grew up in the Valley, and a lot of my friends were involved in the startup and venture ecosystem. So, I watched it from afar when I was a kid. And obviously now I’m a venture investor, so a lot of venture investors began raising SPACs in 2020 and 2021, actually for a good reason. Their logic was if I have an early stage venture fund, and I’m investing half a million dollars in your seed and Series A, and you grow to become a bigger company at the Series C and D and E stage, well, then a lot of venture funds would actually raise opportunity funds, which are basically another term for growth funds.

Joe Zhao: And then SPACs became an extension of that where now the venture investors are saying, hey, look, if you are so good and you’re going to grow from being a growth stage company, basic growth stage companies are Series C and D, to almost an IPO, public market ready company, you’re talking Series E and F and Series G, and you’re basically talking pre-IPO, the venture investors wanted to show continuity by providing their portfolio companies with a vehicle to go public, hence a SPAC. So, I think in that context, a SPAC was used in a brilliant way because it gives venture investors a way to basically stay in front of their best portfolio companies at every point of that portfolio companies’ lifecycle, from early to growth to late stage. So, basically, it’s like I’m offering you a whole suite of lifelong services from pre-idea to post-IPO, I’m here no matter what.

Joe Zhao: So, a lot of venture funds raised SPACs with that goal mind. And that was actually a brilliant idea because founders also loved it, because founders are like, “You know what? You backed me when I was a two-guy team. You backed me again when I was a 20 people team. And now, I’m going to go public, I’m at 1,000 people, I want to work with you again.” So, there was a lot of synergies between founders and SPAC managers in that context. The SPAC sponsors that were independent sponsors, I’ve seen some of those SPAC sponsors around, but the ones I felt most comfortable with were the SPAC sponsors who were venture funds that had an early stage strategy for growth and late stage strategy. But obviously now, I would put SPACs at the riskier part of the spectrum of assets.

Joe Zhao: Again, like when we were talking about Fed policy, if you rank assets by risk volume, you’ve got CDs, riskless treasuries, fixed income credit, and then public equity, private equity, SPACs, and growth. I think what’s happening today, when a lot of folks are redeeming their shares in SPACs, and a lot of SPACs are not only unable to raise new capital, but some SPACs are shutting down now, and you’re seeing some of the capital flow out of those SPACs and back into some of the riskless assets, is a symptom of the same underlying trend that we discussed earlier, which is when rates go up, Fed policy changes, investors are reallocating away from the riskier part of the spectrum and into some of the riskless part of the spectrum.

Joe Zhao: And I think that’s why we’re seeing SPACs becoming less of an asset class and by the same token with some of the crypto stuff and some of the private markets and some of the public market stuff. Now, do I think this trend is here to stay? I think these things always overshoot, so for me as an investor, I’m actually working on some of the really good opportunities in not only venture growth and SPAC and crypto, because I do think that the pendulum is going to shift back at some point, but I think what’s happening with SPACs is that companies don’t want to merge with SPACs anymore for all those reasons that we’ve seen in the last few years. And also, investors are cutting back from SPACs and going back into some of the fixed income stuff.

Frank Curzio: No, it makes sense. So, what are some of the things that you’re investing in? Can you share any ideas with us? I know some of them might be private, but even sectors or maybe things to… And I think we talked about a lot of stuff to avoid, maybe not specific stuff, but you could say that, hey, you know what, I’d be very careful, you said right now, especially as people see the balance of their portfolios and things coming down and that sentiment factor. But what are some of the things that you like that you’re investing in?

Frank Curzio: And I know you talked about crypto as well, and I see that impacting the Fed, the Fed are talking about a crypto a lot more where, again, this is something that’s fixed. Some people are going to store value, even as a currency where it can be used for certain things, it’s not being inflated, diluted, or whatever. But what are some of your thoughts, I don’t know if crypto is one of those things, but what are some of the things that you’re looking at now? Because you know as well as I do, with markets like this, when they’re down, a lot of people want to sell, it’s easy to highlight the risk, but this is where the people that you’ve studied, that I’ve studied, I am 50 today, by the way, but I’m still studying, we’re always a student.

Joe Zhao: Always learning.

Frank Curzio: But this is where they thrive, in markets like this, it’s not buying things at the top and riding them another 20%, 30% higher, it’s, hey, we have cash on the sidelines, this is what we waited for. So, what are some of the things that you like?

Joe Zhao: For sure. So, at the early stage we’re looking for repeat founders, basically founders who’ve built companies before who have started new companies, and that’s just a winning formula, if the concept makes sense. And, yeah, the fact that they’ve started a business, sold it for 20, 300 million dollars, a billion dollars, they’re starting a new company, those are founders that we absolutely want to go after. And we also look at some of the YCombinator companies. So, YC is a startup incubator. My analogy is YC is like a Harvard business school slash Stanford slash Wharton slash all the top five, 10 schools. So, it’s very difficult for a new startup, a new idea, to get into YC. I think the success rate is 2%. And then, we will invest in probably the top 10%, 20% of those companies.

Joe Zhao: So, we’re really investing in the top 40 base points of all private companies that get into YC. So, imagine you’re backing individuals that are top 40 basis points of every graduating class coming from HBS, Stanford, or Harvard Law, whatever field they’re in. I think that’s also another recipe for hopefully success. At the growth stages, we’re investors and we can’t time the market. So, we don’t want to not invest just because the Fed says X-Y-Z, the Fed pivots to X-Y-Z. They can pivot 180 again tomorrow if the data proves that… So, we want to find just fundamentally good companies that are introducing real innovations, that have real good revenues, and the unit economics make sense in private markets. So, basically our secret sauce is, we look at a lot of public companies in their categories, and we try to look at private companies that resemble these successful cases at any point in time.

Joe Zhao: So, that’s one strategy. Another strategy is we can be a value investor, meaning we want to apply a value investing approach to looking at private assets, meaning we want to find private market assets that are undervalued. And there are ways you can validate that. For example, if you see a private company that haven’t raised money in eight years, well, guess what? The valuation that they raised eight years ago is likely outdated. So, you can look at some of the secondaries in those opportunities. There are a lot of tactical ways that we can still generate a lot of alpha in private markets. When it comes to just our overall macro outlook, here’s our view on crypto. Crypto is a real good innovation, and so are a lot of the innovations in private markets, whether you’re looking at cybersecurity, cloud and data and SaaS, and FinTech and payments. Another thing that we really like right now is the emerging markets versions of US companies.

Joe Zhao: So, for example, this company we’ve seen, they want to be the Stripe for Africa. They want to be the Stripe for LatAm. And those early stage private companies are a great opportunity because we know that the business model works, so they just have to copy, paste, modify, and obviously their market size can be a little smaller, can be a little bit bigger, but you know that you have a blueprint. And if we’re an investor in both a US company, let’s say we’re invested in SoFi, and we’re also investors in the Latin version of SoFi, well, guess what? We can let the private company in Latin borrow the blueprint by SoFi in the US to let them copy, paste, and modify, so hopefully they can go to market much more quickly. And we can also even just introduce SoFi’s team and their team in LatAm to make sure that they sync, so the Latin version don’t make the same mistakes or follow the best practices.

Joe Zhao: So, there’s a lot of really good strategy and tactics that one can use in private markets to generate alpha. But our view on crypto is crypto is a really, really, really good innovation. There’s right now a lot of hype, but the technology is here to stay. So, we’ve been looking at some of the blockchain infrastructure layers. And our thinking here is we don’t know which token’s going to win out in the next five to 10 years, we don’t know if it’s going to be Solano, Ethereum, Avalanche, but we want to bet on the casino. So, there’s two ways we’re playing the crypto market. One is we’re buying the infrastructure layer. We’re investing in companies that provide the coding, the development, because no matter which token wins out, they all have to use the casino, if you will.

Joe Zhao: The second strategy that we’re employing in crypto is we want to actually gain a diversified exposure to a fund of fund, because that way we’re betting on the whole sector, so we’re not putting all of our money on one token. But I do think on crypto, I think one of your comments was the Fed began looking at crypto, my understanding and just by looking at some of the stuff they said and they put out is there’s two reasons why I think crypto is becoming a higher priority for the Fed. And there’s a third reason for why, what happens in crypto may not change Fed policy. First is when crypto motto is we’re going to challenge the Fed, well, of course, if someone comes to me and says, I’m going to challenge you, I’m going to pay attention.

Joe Zhao: So, I do think that they do have to pay attention. But the second reason crypto became something that they talk about is because the asset class grew very quickly from basically zero to two, three trillion last year. Obviously three trillion is still a very small market in comparison to US equities, which is a 30 trillion market, fixed income, much bigger. But I think when something grows that fast, they will probably put it on their financial stability radar. And again, remember when we talked about financial ability.

Joe Zhao: Financial stability is a third priority for the Fed, way below maximum employment and priceability, but within the financial markets, indicators they look at are things like fixed income, they look at fixed income first because that’s a huge market, and monetary policy transmits through the fixed income market. Public equities, private equities, and then crypto, well, here’s why the Fed may not change its policies for what’s happening in crypto is because, again, crypto is a new player amongst a team of 10, but it’s the smallest player if you line them up against public market, private market, fixed income, credit, et cetera.

Joe Zhao: I just don’t see how the smallest newcomer, even if it were to blow up or otherwise, the Fed would change its old financial markets stance. But there’s something that could happen in crypto that can change the Fed’s stance on crypto. And that is if crypto becomes a risk to financial stability. And there’s a couple ways that can happen. If regulated banks like the Goldmans, JP Morgans, and the banks like that, that go through the Fed’s CCAR every year, if they began underwriting and taking on crypto risk on their books, by the same token that the banks had underwritten mortgage backed security risk 10 years ago, that a collapse of crypto prices can basically hurt the books and liquidities of the banks, that’s when crypto I think becomes a higher priority for the Fed to monitor. But as a market itself, it’s so small relative to fixed income equities that I don’t see the Fed… The Fed might put an eye on it, I don’t see the Fed changing its stance on crypto.

Frank Curzio: No, I love it. Getting the inside perspective. So, this last thing here, anything personally, and I don’t know if you could say that you’re looking at this market that looks attractive to you, that you’re purchasing in that the publicly traded markets, that you see, hey, you know what, this has come down enough or put money, because I know right now your focus is on the private markets and finding those ideas and the formulas and things, that’s amazing. From my perspective, I’m hoping that goes well with our audience, but for me, man, I’m just blown away. It’s great. I love hearing stuff like that and learning.

Joe Zhao: I hope so too.

Frank Curzio: But anything right now that you’re looking at or maybe that you would be, hey, you know what, probably it’s a good sector to short right now or anything like that? Or again, if you can’t say that, that’s perfectly fine, but I know my audience always likes new ideas.

Joe Zhao: I actually have a couple of ideas. So, there are some IPO stocks that have been over punished, that are trading near their cash flow levels, that are actually cash flow positive. And they’ve raised 200, 300 million in their IPO round, that have three to five years of cash runway. So, it’s crazy because if you read the financial press, they’re all saying get away from the profitless technology companies. So, people are selling those and going to some of the blue chip tech companies and even some of the traditional companies, the industrial companies. But I think that to some extent been overdone. Here’s two reasons why I think some of these new IPOs are great opportunities. One is they’re growing 30%, 40% year over year, which means if they keep up those CAGR growth rates, their revenues are going to double and triple in the next three to five years.

Joe Zhao: Second is their values are down because they’re not profitable, so people don’t want to hold them, but they’re not profitable on a gap basis, but they’re actually profitable on a cashflow basis. And it’s cashflow, that’s what really counts for these companies because it’s cash flow that really go back to the balance sheet, because people draw what’s happening to the tech IPOs today to 20 years ago. And there’s a huge difference between what’s happening today and 20 years ago.

Frank Curzio: Huge.

Joe Zhao: 20 years ago, obviously I was a young kid, but 20 years ago, some of these new IPOs had no revenue, no product and no free cashflow. 20 years later, I think founders and VCs have learned some lessons in the last 20 years that some of these companies have 200, 300, 400 million dollars of revenue.

Joe Zhao: They have 80% gross margins, and their free cashflow may be negative 5%, yeah, you can call that unprofitable. But if they can literally turn a switch and become cashflow neutral, so they’re not losing cash, they’re not making cash, but they’re neutral. And when they’ve raised like 300, 400 million dollars of capital on balance sheet, that means they can stay in business forever now some of their stock prices are right now trading at near their cash flow levels which is such a huge bargain.

Joe Zhao: And one can argue, well, look, well if your DCF, if they’re unprofitable, yeah, they should be trading at that level. But what I can also guarantee you is that the Fed policy is going to change sometime in the next five years. If rates are going up today, I think there’s a really high probability in the next five years that rates are going to go down at some point.

Frank Curzio: Morgan Stanley, Evercore are predicting that 2024, they’re going to come down. So, even sooner than that, yeah.

Joe Zhao: Right. So, then if 2024 rates go down and we go back, and so you lower the discount rate, then wouldn’t now be a great entry for getting out of those tech stocks in 2024 when they become profitable, their revenues are three times bigger? And the DCF model now works again for these tech companies and you can get a five X. So, I do think, that’s why I was saying that some of these IPO stocks are over punished, and you can just use Bloomberg and just filter out the companies that are trading at their cash flow level that are ideal companies that have a lot of cash and they’re almost profitable. I think those things can really do well in the next three to five years when the Fed’s policies may change again and they begin the lower rates.

Frank Curzio: No, it definitely makes sense. So, I could keep this conversation going, we try to keep it 30 minutes. I think we’re at 45 minutes and we had so much because I know you went to Milken Institute, which, you know what, if we could do that in two minutes too, I know you went, that’s a massive conference. There’s just so many different topics, but you have the CEO of Qual come there, you had Mary Barra, the CEO of General Motors. And also you have a lot of politicians there, you have media personalities from Bloomberg, CNBC, and a lot of private equity. I know we wanted to discuss that in terms of sentiment, and we’ve got two minutes left to talk about that. How was sentiment there? Did you see a change? You’re a CEO, your job is to be optimistic.

Frank Curzio: And I get it. I understand that. I talk to a lot of CEOs. But is it tough in this environment where you’re like, whoa, not only is it tough to manage your supply chains and you look at it from a GM point of view. Now you’re looking at trying to get the supply in, and now you’re sitting on inventory, it’s like we saw with Target and Walmart. Now, all of a sudden, when your inventories are getting better, at better levels, you’re seeing demand fall off. What did you hear at this conference? And, yeah, I’m just curious, that’s a very, very big conference.

Joe Zhao: Yeah. Two things. On the economics, inflation is such a wild card because if the inflation were to come down to 7% on June 11th, the next time the data comes out, I think we’ve had a bad scare. And secondly, if inflation comes down two months in a row, that’s some of the sentiment that I saw there. If you see inflation coming down two months in a row, then you see the trend of inflation moderating, then folks become a lot more bullish about the state of the markets. And I think that’s when folks would get back into the market and prices go back up for not only fixed income but also equities. On the equities front, there was a panel by Cathie Wood and some of the value investors like GoldenTree and Davidson Kempner’s founders.

Joe Zhao: And it was funny because it was four value investors and one growth investor, so Cathie… And the overall sentiment, and I talked to people after the conference, after the panel, was that they feel like what’s happening in technology today, some of the stocks that Cathie Wood has, reminds them of 20 years ago, but as a milder version of it. So, Cathie Wood’s stocks have fallen by 80%, and a lot of the IPO stats fell by 80% 20 years ago. But again, there’s that silver lining, which is what I mentioned earlier, that the new tech companies are here to stay. And so if you have a long investment horizon, and these companies are here to stay, I think the valuations will normalize to somewhere if that makes sense.

Frank Curzio: No, that definitely makes sense. Well, Joe, we’ll leave it there. Listen, we covered so much, I really appreciate you coming on, and hopefully you’re going to join us again soon, but thank you so much for the insight. If someone wants to learn more about you or get in touch with you about your fund, how could they do that?

Joe Zhao: Our email is mgmt@millenniallp.com. It’s also on my LinkedIn, so feel free to email me, I love to kind of talk about private markets and Fed policy, and thank you for having me. Thanks to John for making the introduction. I really just find this medium to be real helpful to share some of the insights on how the Fed thinks about policy and hopefully people can leverage the Fed in your favor than against it.

Frank Curzio: No, that sounds great. All right, Joe, thank you so much for coming on, and hopefully join us again soon. Thanks, man.

Joe Zhao: Thanks so much. Bye.

Frank Curzio: Guys, great stuff from Joe. I said earlier, John Petrides introduced me to him, this was a few weeks back, and we just had a long conversation and I was like, wow, this guy’s smart. We were just going back and forth sharing our ideas. And there’s certain people that you speak to that you just click with. And I clicked with Joe and we had a lot in common, and it wasn’t even that, well, we share the same insights. I like it when I talk to smart people and we don’t share the same insights sometimes, which is cool. But Joe and I agreed on some things, and we were just talking about the markets and everything, and the fact that we’re doing a deal with our company right now through private placement and stuff we were just going through, we really clicked.

Frank Curzio: And I just thought that a lot of that conversation was relevant with what’s going on right now, the Fed and the private equity markets, the reset. But again, a lot of this stuff happens, it gives you an opportunity to really invest money at a great, great time. And I know it always feels like, holy shit, I need to get out of this market, it’s terrible, inflation, all these concerns that I highlight all the time and even Joe mentioned in that interview, but those are usually the best times to invest for long term investors.

Frank Curzio: And I’m not talking about long term being in five, 10 years. I’m talking about the pain that we’re seeing right now, and it’s going to get a little bit worse before it gets better, but the valuations that we’re seeing, where valuations are at below levels, COVID levels, March, 2020, early April, 2020 is insane. Small caps are trading below those levels. And a lot of these guys aren’t going out of business.

Frank Curzio: Yes, things are worse than what they’ve been. Yes, consumers are cutting back. But again, the Fed is going to be in a position to lower rates later on, and we’re going to see inflation moderate, especially with the news that we just heard this week from Target and Walmart. So, just a great interview there, but I always say this, this interview is about you, it’s not about me. Let me know what you thought of that interview at frank@curzioresearch.com, that’s frank@curzioresearch.com.

Frank Curzio: And that’s it for me, guys. Questions, comments, next week’s podcast are on Tuesday and Wednesday with Dan, and we’re going to be taking more and more questions, with the market all over the place. We are getting lots of questions. I want to be there and answer that for you. So frank@curzioresearch.com, feel free to send me questions, and we’ll answer them in Tuesdays and Wednesday’s podcasts and try to set up some really great interviews that are relevant, just like we did today with Joe. And again, we’re here for you. Feel free to email me anytime and have a great, great weekend. And I’ll see you next week. Take care.

Announcer: Wall Street Unplugged is produced by Curzio Research, one of the most respected financial media companies in the industry. The information presented on Wall Street Unplugged is the opinion of its host and guests. You should not base your investment decision solely on this broadcast. Remember, it’s your money and your responsibility.

Frank Curzio, founder and CEO of Curzio Research, is one of America’s most respected stock experts. His research is regularly featured on media outlets like CNBC’s Kudlow Report, The Call, CNN Radio, ABC News, and Fox Business News. His Wall Street Unplugged podcast—ranked the No. 1 “most listened-to” financial podcast on iTunes—has been downloaded over 11 million times.

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