Transcript
Stephan Shipe: Welcome back to the Scholar Wealth Podcast. This week, a tech executive in the Bay Area working through IPO allocation strategy after mixed results on SpaceX, then a family exploring irrevocable dynasty trusts for long-horizon private investments and whether the running costs actually pencil out. And we close with a listener asking about Bitcoin arbitrage funds, market neutral on paper, and how to think about strategies like that on their merits. Let’s go ahead and start with question one.
Question 1 – How to Think About IPO Access, Brokerage Relationships, and Allocation Strategy
Stephan Shipe: I’m a tech executive in the Bay Area, mid-forties, around eighteen million dollars invested. I participated in the recent SpaceX IPO with a fifty thousand dollar indication of interest through Schwab and was offered thirteen percent. On another IPO a few weeks ago, I got nothing. Talking with friends, allocations are all over the map, depending on the brokerage. I want to be more strategic about this, not to chase pops, but because IPO access seems to be one area where how you set things up actually matters. How should someone in my position think about which brokerage to maintain for IPO access, how to size indications of interest knowing partial fills are the norm, and how to handle the allocation once it lands?
So we have a lot to unpack here. I think it’d help a little bit to give some background on the IPO process before we get into a little bit of the strategy. So the way it actually works — a company wants to go public, so SpaceX is going to go public. They’re going to raise money by selling shares to the public. The big misconception is that people think that when they buy shares on the day the company goes public, they are giving money to SpaceX. And that’s not the case. That is actually done early on in the offer price. So at the offer price, investors come in and say, all right, I’m going to give SpaceX $50 per share, and SpaceX in turn is going to give me a share.
That’s what we’re talking about here. We talk about this indication of interest. The broker will go out and say, I’ve been allocated millions of shares that I need to push out to clients of mine. And then clients submit interest and say, hey, I want to participate in the SpaceX IPO. I want to do, like in this case, $50,000 of SpaceX interest. And then the broker says, all right, we have all these shares to allocate, we’ll allocate you a certain amount. And in this case, only 13%. That is not uncommon for oversubscribed or very popular IPOs. So that’s when you hear that partial fills are normal. They are normal for the ones everyone wants to get into. They’re not normal for the ones people don’t want to get into. You can get your full order or indication of interest typically filled.
Where this becomes a problem is that if you are the underwriter, there is a — not even a phenomenon around this, a norm — that is IPO underpricing. It’s been well researched, it’s well known, right? There’s lots of data to support IPO underpricing, which means that when a company like SpaceX initially issues their shares and gives that to investors, typically the change from that issue price, let’s say it’s $50, to the close of the first day it trades is higher. So that pop on that first day is well documented. And usually it’s around that 18, 20% mark. So to your point of this being profitable — it absolutely can work out. And on average, you’re looking at an 18% jump if you participate in the actual offer price where you’re giving the money to SpaceX, not you buying SpaceX at nine thirty in the morning and selling at four. That is not actually the time where, on average, a lot of the money is made.
Now there are lots of reasons for IPO underpricing, and lots of speculation and hypotheses, but what is generally documented is that if you’re a company going public, you want your offer price to be appealing enough for it to be subscribed. You don’t want to go out and say, I need to raise a hundred million dollars, so I’m going to list my price really high, because then the investors look at it and say, there’s no way, I’m not interested. And you’re not actually going to get your hundred million dollars. So you have to drop it down a little bit so you get enough interest.
There’s also the other side of that from the underwriter perspective. SpaceX goes public, or any company wants to go public. Usually you’re only going public once, maybe a couple of times in your life. So when the underwriter, the banks, are actually going in and trying to price this and say, you know what, I think you should go public for $50 a share — they have competing interests. They know that they have to go get as much money as possible for the company, who will likely only be their customer once, maybe twice. But they also have to say, as soon as they get that price, hey, I think you should go public at $50 — they’ve got to take it to all of their thousands of clients. And they have to say, I think you should buy this IPO and it’s going to be $50. Who do they want to impress the most? Who’s the conflict being driven by? In many cases, it’s the clients, because they know that if they come to me tomorrow and say, hey, Stephan, we want you to participate in this IPO, we can get you in at $50 a share — if I get in at $50 a share and on that first day that price drops to $30, I’m not happy. And next time they come to me and say, hey, Stephan, I want you to participate in this IPO, my answer is going to be no. So that’s hurting them, because now they don’t have all of these allocations already filled. It makes their job easy if they can make phone calls to me every couple months and say, hey, I have a new IPO, do you want to participate? And I say, yeah, that sounds great.
So how do they keep me saying yes every single time? They keep me saying yes by making sure that they allocate me IPOs that have a decent return. So that’s where that first-day run-up, that first-day pop, is super important to justify what you’re talking about. Now, interestingly enough, after the first-day close, for that next three years or so, the returns are actually less than the market. So that first-day pop is when you want to participate, which is why there’s so much interest in getting actually into the true IPO with an indication of interest, or an IOI. So you send this into your broker and say, hey, I want to allocate, I want $50,000 of allocation. And then they do all their math and say, here you go. And that is determined by a lot of things. It’s determined by how big of a client you are. It’s determined by how much they kind of owe you for past opportunities or past relationships that they’ve had, different types of products and services you’ve used on their end. So there’s a lot of gaming that goes into that to see if you’re a preferred client that’s going to get a higher allocation.
And you say, well, I’ve got plenty of money, that’s going to be completely fine. That is not who you’re competing against. You’re also competing against all the other institutional investors. You coming in for $50,000 at an indication of interest is low. That’s nothing compared to the hedge fund that said they want $20 million, $50 million of allocation or even more in these cases. And these IPOs, you’d be raising billions of dollars. This is not going to be an easy lift for somebody to come in.
So those are the preferred clients they’re going to be dealing with. Now, how can you help yourself in dealing with that one? And I think this is probably part of the issue — you’re going through Schwab, and that’s not a knock against Schwab. I’m a big fan of Schwab as a brokerage firm and everything else, but they’re not the one actually getting the allocation. In other words, if you go to a JP Morgan or a Goldman or a Bank of America, they’re the ones that are actually underwriting these deals. So they’re going to have more access. So if you’re looking for who to have relationships with, having relationships with the actual banks that have an investment banking division that are actually being the banker on these deals is going to have a lot more access to IPOs overall.
And then you get into this idea of how many of these relationships do you need? Now, if this is the path you’re going on — that you want IPO access and you want this because you’re going to get this nice pop — I really would encourage you to think more about what is the real return? Because when I’m saying 18, 20% on average, that sounds great. But how many IPOs are you actually going to get in on? Because IPOs in general tend to be riskier. So if this is three or four IPOs a year that you want to get in on, maybe you have two or three different brokerage relationships. If you’re only putting $20, $30, $50,000 into each of these deals, maybe you make an extra $10,000 of return for now multiple banking relationships with multiple IPOs, some of which may have lockups, different issues on when you can sell, what type of access you have to them. So you’re adding a lot of complexity for an account that’s not likely going to be getting a ton of its indication of interest filled. So I don’t know that I’d necessarily look at IPOs and go through all of this as an actual strategy.
I would look at it more as part of the game — that every once in a while there’s going to be a big company that goes public that everyone’s excited about, like SpaceX, like Anthropic, like some of these others that are out there. But it’s few and far between. If I asked you to tell me what are the last two or three IPOs that you would have participated in, or wanted to participate in, that you missed out on — if you can come up with a list of three, I bet they all didn’t happen in the past six months, and they’re probably spread out over the past five to ten years, which would give you an idea of how much you’re actually missing out on. And I don’t think it’s actually that much. So a lot to take in on that one. But there are ways to increase the fill on that. I just don’t know if going through all the hoops to do that is actually going to make a lot of sense for the portfolio.
Question 2 – Do the Costs of an Irrevocable Dynasty Trust Actually Pencil Out for Long-Horizon Private Investments?
Stephan Shipe: I’m exploring whether irrevocable dynasty trusts make sense for my children, with the primary goal of investing in direct deals, venture funds, and SPVs over a very long time horizon. What’s kept me from acting on it is a long-held assumption that the cost of running these trusts — setup, trustee, administration — would be high enough to outweigh the benefits. I’d like to pressure test that.
Me too. So let’s get into what that actually looks like. What you’re talking about, the cost — I’d say we knock out a few of these costs right away. The setup costs and the actual legal fees and even the tax filing — that’s generally not as big of a concern. The big fee that we’re really trying to battle against in this scenario is going to be the actual trustee administration fees. That’s where you’re really going to eat into the cost of this.
Now, to put that in perspective — you’re probably, if you’re looking at a directed trust, which is what I would likely see in the scenario where you’re the investment advisor essentially for the trust, you’re handling the investments, you’re looking at all these SPVs and venture funds and direct deals, that’s all still under your control. And you have someone just running the administration and the distributions, which is the key, because you don’t want to lose the irrevocable nature of the trust. So you’re going to want to talk to your attorney about making sure that that’s structured in a way that’s not going to get you into any trouble. But generally in that, you’re looking at maybe 10 to 30 bips, or 30 basis points, on cost for having someone just handle the administration part of it, which can start stacking up really fast. I mean, if we’re talking about even just $10 million in a trust like this, that could be $30,000 in fees just to handle the administration of it. If they’re handling the investments and everything else, now you’re looking a lot like a traditional advisory relationship with AUM, and you’re going to be closer to that — maybe 50 to 70 basis points if you have sufficient assets that pushed you into these different fee breaks. But it could be as high — I’ve seen one and a half, close to 2% on trust management, especially depending on what’s in the trust and what you’re looking for, which goes into the next point.
The level of complexity you’re adding, and somewhat the cost for those administration fees, are going to be based on what types of investments are in that trust. So when you’re starting to talk about these illiquid holdings, you’re starting to add different types of valuation concerns — K-1s, distributions, there’s a lot of added complexity going on that may raise that administrative cost and add a lot more complexity for you as the investment manager, so to speak, or investment advisor on that trust. So when we’re talking about true costs, that’s the bucket that I would throw all the costs into. I wouldn’t consider the setup fees and all that. It’s really the administration aspect that’s going to cause the cost.
So then if we’re looking at that cost, now we have to weigh that against the benefits, which is what we’re trying to pressure test here. The benefit of getting into some of these illiquid assets is usually a couple hundred basis points a year. So maybe two, three percent extra over a long time horizon. I imagine that’s the goal here, especially since you’re looking at the dynasty trust.
The thing that throws me off a little bit — you said that you’re exploring whether irrevocable dynasty trusts make sense for my children, but the primary goal of investing in direct deals, et cetera. This really wouldn’t be as much for your children. The fact that you’re setting up the dynasty trust and likely taking the GST, or the generation-skipping exemptions that are available — the benefit of that is you’re kind of pushing that to the grandkids. And the stuff you’re talking about investing in, these are multi-decade holds where you’re not looking at getting out of this in four to five years. Despite what they tell you, you’re going to get into a lot of these deals and they’re going to say that they’ve got a goal of being liquid in five years, seven years. I’ve seen funds that were supposed to be liquid in five years go on for 20 years, and some of them even 30 years, that were supposed to be liquid a long time ago, and they’re still held in my clients’ portfolios. So we want to be prepared for that.
So if this is truly a dynasty trust, where you’re not looking at this for your kids but more so grandkids, great-grandkids — truly generational wealth — then you’re going to be invoking likely some sort of generation-skipping arrangements where you’re going to use that exemption. One of the biggest issues that people run into is they set up these irrevocable trusts and they don’t elect for any of the generation-skipping considerations. So you’d want to make sure that’s set up as well with your attorney. But once all that is completed and you start looking at the types of investments, I don’t think it’s unrealistic that a long-term portfolio, if you’re handling the investment side of it, could outweigh the administrative cost of the directed trust. Because like I said, you’re looking at a fee drag of close to maybe 10 to 30 basis points there, which you would imagine and hope that if you’re running a long-term aggressive portfolio that’s meant for multiple generations, and you have sufficient liquidity in it to diversify those types of illiquid investments — so that way you get to participate not only in the type of risky bets that you’re getting into, but also the vintage of those risky bets — I think it could work out.
The issue is always, when you do this, who’s going to run it after you? You’re dealing with a generational trust, you’re dealing with the investment allocations. Are your kids going to be interested in managing this after you? Because if they’re not, then you need to be able to pressure test — is the trust able to withstand a tripling or more of the fee once you’re no longer the investment advisor, and you have somebody else managing the whole thing and now they’re charging the one percent or one and a half percent, 70 bips, somewhere around there, that you’d be dealing with. So that’s where it’s going to be. Obviously, the location matters as well. All the typical attorney conversations of structure on GST, structure on where it’s located, what distributions look like, are going to be very important on this. But from a pressure test perspective, based on the information we’re talking about, I don’t think it’s crazy to set it up if you’re truly setting up a dynasty trust with the goal of this being multiple generations — not I’m setting up a dynasty trust because I like the name of it and it sounds neat, but really my next generation, that second-generation children, are going to use up all that money anyway, so there’s really no dynasty to it. That’s what I’d be looking at.
Question 3 – Bitcoin Arbitrage Funds: How to Evaluate a Market-Neutral Strategy on Its Merits
Stephan Shipe: I’m considering investing in an arbitrage fund for the Bitcoin space. Do you have any insight or experience with similar funds?
Absolutely. So arbitrage funds, or any type of market neutral type funds, work out in a way where you’re going long and short similar assets and hoping that prices converge. A really easy example to give — let’s say we assume that Delta Airlines and American Airlines should be affected by the same macroeconomic factors over the long term. And if they’re affected by the same factors, and we’d assume that they trade similarly, that one’s not going to really outperform the other and they’re going to do the same — then maybe one time Delta goes up significantly in price and return, and American Airlines is staying flat. What we could do is we could go short Delta and go long American Airlines. So let’s think about what ends up happening then. If we do that and they converge, Delta should come down, American Airlines should come up. And we were correct. We shorted Delta, so we’ll make money there. We’re long American Airlines, we’ll make money there. And you’ve officially made a market neutral portfolio, because regardless of what the market did, your profit is only based on the movement of the convergence of that gap.
What I mean by that is, let’s think about a scenario where the market drops. Well, if the market drops, both of those stocks should drop ideally by the same amount. So if we see Delta drop by 10% and American Airlines drop by 10% — well, we were long American Airlines, so we lost 10% there, but we were short Delta and it dropped 10%, so we actually made 10% there. So we’re market neutral. We don’t care if the market goes up, market goes down, market goes sideways. The return from the market is irrelevant because we’re always long one and short the other. All we make a profit on or not make a profit on is whether that gap between the two assets converges or diverges. The risk is divergence. If you have a situation where we’re short Delta, we’re long American Airlines, and Delta now goes up and American Airlines goes down and that gap gets larger, now we’re in trouble because we’re short the thing that went up and we’re long the thing that went down.
And that’s the same thing with these types of funds with Bitcoin. As you can look at, generally the common structure here is going to be buying the spot price at the actual price of Bitcoin and shorting in the futures markets with Bitcoin futures. What that would allow you to do is the same thing we’re talking about — you go long Bitcoin at one price and you short Bitcoin at ideally a higher price. And when those two prices come together, you match up and that gap closes and you profit on the gap. That can be very helpful if there are differences in what the value of assets are, or the value of instruments of assets that are the same. So while we’re talking about a futures contract and actually owning Bitcoin — two totally different structures, same underlying asset — we could see them converge over time.
The issue you have with these types of structures is the way it’s going to work, especially if the funds you’re looking at get into some of these futures contracts. Because if you see, let’s say, Bitcoin spike significantly — let’s say for ease, let’s use a spot price of Bitcoin, even though I know it’s not there, of $100,000, and you go and short futures for Bitcoin at $110,000. There’s a $10,000 spread that you’re hoping collapses. What happens when Bitcoin spikes up to, let’s say, $160,000? Now your spot is in the money, right? You have paper gains on that of $60,000, but you’re negative $50,000 on the futures contract that you sold short. So you could still immediately close out today and make $10,000 on it. But in a lot of these funds, it’s not that easy. There are transaction costs on it, there’s counterparty risk. In other words, you have to make sure that the funds are actually delivered, or that the Bitcoin actually exists. There’s custody, ongoing fees. A lot of these are leveraged. So I didn’t actually go buy the $100,000 Bitcoin — I borrowed money so that way I could buy the $100,000 Bitcoin. And if I’m borrowing money for the $100,000 Bitcoin, now I’m paying interest on that. So if it takes a lot longer for that gap to close, now I’m stuck paying interest on a loan for a position that hasn’t closed yet, or they start to diverge. And that causes problems, just like that American Airlines and Delta example.
So the biggest risk that I see on these by far, on any type of these funds, is they look fantastic on paper. I could draw, if I had a whiteboard here, I could draw you the greatest picture of what market neutral looks like and show you examples of what happens when American Airlines and Delta move, what happens when Ruger and Smith & Wesson move against each other, what happens with Pepsi and Coca-Cola. There are tons of examples that I could give that show nice pictures on a board of one line going up and another line going down and them converging and big dollar signs that say, well, this is what profit looks like when they move together. The problem is in action.
In reality, when you’re actually doing this, we have to take into account transaction costs. We have to take into account borrowing costs on this. We have to take into account how long it takes for these actual inefficiencies to converge. It could take years. So are you going to have years of running a strategy before the convergence actually happens? Lots of concerns that we want to get into and be very careful on, especially with something like Bitcoin. And it’s not necessarily a knock against cryptocurrency or Bitcoin anyway. We just haven’t seen a lot yet. I think that’s kind of a good thing for Bitcoin, and maybe it’s a separate discussion further than what you’re seeing here. But there was a lot of discussion five years ago on Bitcoin that was, well, Bitcoin hasn’t been tested, hasn’t been around long enough to see ups and downs of markets. And now it’s getting there, right? We’re starting to see a little bit more time where Bitcoin has been owned, and it’s been through some market crashes, and it’s been through some bull markets and some down markets. We’ve seen how it reacted against gold and all this. So I think the age of Bitcoin is actually helping it out and giving a little bit more credibility to these types of funds. But these types of funds are now an added layer, an added new layer of complexity on Bitcoin that I think puts us at risk a little bit of not knowing how they’ll work out at a time when we’re just now trying to figure out how Bitcoin itself is working out. And now you’re adding in different instruments.
So I don’t think there’s anything wrong with it. I would just be very hesitant to put a lot into one specific strategy based on this, knowing that a lot of it can’t be back-tested for more than just a couple of years. And I bet you if you look at a lot of the prospectuses that you’re looking at for this type of fund, they’ve only been around for a couple of years. Or even worse, it could be just all theoretical and they’re showing you back-tested data of, this is what the returns would have looked like if we would have implemented this. And you’ll see these things that say, this is what would have happened in 2022 with this exact strategy that we back-tested based on our program. And that is absolutely correct. And I’m not knocking the data — the data is probably accurate, that that is what would happen on paper in 2022. But the reality is we’re not in 2022. And we don’t know if, by placing that trade, the market would have moved against it. We don’t know if, by placing that trade, the volume was even there. And that is always the key question to ask. And it works whether you’re talking about in practice or even in academia — it is, what are the transaction costs that you’re including here? Because a lot of times that transaction cost question can’t be answered. And it shouldn’t have an answer, because no one really knows. Anytime there’s any back-tested data, it should say what is the transaction cost that you’re accounting for. And you should run away if they say we’re not accounting for any transaction costs. Huge red flag. If they give you some answer like, we’re accounting for, you know, 50 basis points transaction cost, or whatever it is — it’s a half answer. It’s just an easy way out. They’re not actually looking at how volume would have interacted with this, what spreads did during that time. The reason they’re not is it’s kind of sending them on a wild goose chase at that point. There’s no real way for you to come up with an answer for what transaction costs would have been during that time, because we’re not there.
So keep an eye on that when you’re looking through this. And those are the caution flags I’d throw out for you if you’re looking at these types of funds — and not throwing it all into one fund. If you’re thinking about this as a true position in your portfolio, you want a variety of not only funds, but a variety of strategies for it. So in other words, you don’t want three funds that are all using the exact same Bitcoin strategy for arbitrage.
That’s our show. Thanks for listening, and we’ll see you next week.
Outro
Disclaimer: The information provided in this podcast is for general informational and educational purposes only, and is not intended to constitute financial, investment, or other professional advice. The opinions expressed are those of the hosts and guests and do not necessarily reflect the views of any affiliated organizations. Investing in financial markets involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, you should consult with a qualified financial advisor who can assess your individual financial situation, objectives, and risk tolerance.