This is a transcription of our Interview with Kevin Lester, CEO at Validus. You can watch the original video interview here or tune in to the podcast episode here, iTunes, Spotify and other podcast apps by searching “Risk Management Show”.
Boris: Hello ladies and gentlemen and welcome to out interview with Kevin Lester, CEO at Validus.
Kevin is a co-founder and CEO of Validus Risk Management, a specialist financial risk advisory firm with offices in London and Toronto. With a focus on the alternative asset management sector, Kevin has pioneered the use of innovative financial hedging tools and techniques in the private equity, private credit, infrastructure and real estate markets, and is responsible for managing over $300 billion in market risk exposure via the Validus platform.
Kevin, thank you for coming to our interview today.
Kevin: It is good to be here. Thanks for having me.
Boris: Kevin, You started your company about 10 years ago and shared recently a picture of four employees in a one-room office in Windsor, UK. Today you are over 60 people, four offices with a fifth planned for NY, and over 100 clients around the world.
Kevin, can you tell me a short story about your unique path in the industry? How did you get to this? Why was there a need for your solution?
Kevin: Sure. I’m happy to answer that. So I’ve always been really interested in Risk, especially in financial risk and started my career working with large corporates, hedging currency, risk, commodity risk and things like that. And after a few years of doing that, the one thing that I realized working in the risk management space is you’re typically seen as a cost center.
And one of the aspirations I had was to move away from being a cost center and to be a revenue generator. In effect I was in Switzerland at the time, I moved to the UK and I started working for a brokerage house here in the UK, and there’s a couple of things that were very interested. One was the emergence of the private capital space as a market.
It was still a relatively large at that time, it was growing very rapidly and it has since grown a huge amount. And one thing we noticed in our work with corporates was the approach towards financial risk management in the private capital space.
It was a bit of an unplowed field, it was no consensus as to what practice there was to some extent, a desire just to bury your head in the sand and not worry about it.
And we decided to set up our own business and try turn that aspiration into reality. It was certainly difficult at the beginning, as I mentioned, within the private equity world or the private capital world, hedging was not something that was well known.
There was a little bit of interest in it, but there was a little bit of a reluctance, I think, to actually engage in a risk management activity as you would see in banks or hedge funds or even in the corporate world.
So we spent two or three years of kind of hard grind having lots of conversations, really trying to educate the market on the importance of first of all understanding market risk and how it impacts portfolios and secondly, how to manage it.
And we did that by talking to people in the industry. Also, we developed some strong links with academia in particular with London Business School, with the head of their private equity program. He was very interested in this field because within the private equity world, it was the one area, I think, which up until that point had been neglected, and if you look at risk management, like you said, for banks or hedge funds, or, you can go on Amazon and it would be hundreds of books.
And there is a very strong consensus as to how to do it, what instruments to use but the private capital world is very different. So gradually we started to build a client base. The industry itself was growing, the private capital market. So that was a tailwind that we had and gradually we got more and more clients.
At that point the business was very much advisory. So we would go in a way, we would help like a management consulting model where we would help clients understand risks, design, hedging strategies.
And at that point, clients began to ask, well, it’s great that you can design these things, but we need help actually building a portfolio, managing the portfolio, having technology to support that.
And so we started to build these functions as well. We built a trading desk and we built an application for our clients and also for ourselves. And that was really the beginning of the growth trajectory. And we had been growing give or take 30 or 40% a year for the last six or seven years.
And so that’s been an adventure for sure, but it’s been a really interesting field because as I said, the private capital markets, it’s a $7.5 trillion market now, it’s still relatively underserved. And for that reason, it’s intellectually stimulating as well as a really great business opportunity.
Boris: Is your main model now SaaS or a software as service model?
Kevin: Yes, we have three main pillars to the business. The first one is the advisory one, which I spoke about, which is the origin of the business, which is very much, a management consulting type of model.
There is also, a trading desk, as I mentioned, which we in effect provide an outsourced front office solution to private capital managers and investors in private capital, like pension funds where we take the hedging strategies that we’ve designed to market. We liaise with the investment banking world to trade derivatives on behalf of our clients.
And then the third pillar is the technology piece, which now, 10 or 11 years later is the biggest piece of the company, in terms of our headcount about half of the team is in technology as either quants or developers. So, yes, in essence to business, you mentioned a SaaS model is very similar to that.
I call it like a technology enabled service, but so far we engage with a client we typically engage across all three of those pillars. So our relationships with clients are a very long-term as opposed to transactional and they get the technology, but also, the front office expertise, as well as the advisory services that we provide.
Boris: Kevin, what does It take to set up a successful business? You already explained what your offer to industry, how do you differ from other software providers or other solution providers and what are some examples of your customers’ use cases?
Kevin: That’s a great question. So I think in terms of differentiation, I think there’s a couple of things I would highlight. So the first is that we’re very practical, so we’re not like a typical consultant or advisory firm that will come in and cope with lots of great ideas and then walk away and allow the client to take it from there.
So we actually in effect eat our own cooking because we ended up trading the derivatives on behalf of our clients, we ended up providing the technology for the client to monitor and report on their hedging portfolio.
So it’s a really a long-term solution that we provide and it’s a very practical one. There is no point for us in designing a strategy, which theoretically looks great, or it might look great on paper, but when you try and take it to the market, it either doesn’t work or has all kinds of unforeseen secondary or tertiary effects.
So, that’s the first one, and then the second one would be, as I mentioned, we’re very much focused on private capital, both the managers of private capital, private equity funds and things like that, but also the investors in private capital, pension funds, et cetera.
So both the hedging strategies that we design, but also the technology that we develop is very much developed to service the unique needs of private capital investors. So if you think about a private equity firm, there’s some interesting dynamics, which are very different to many other investors or corporates for that matter.
So you’re looking at typically, a very long time horizons, you could be looking at five, 10 years plus in the case of some infrastructure funds where you’re trying to manage these exposures over extended time periods, which you can have bring lots of interesting challenges like liquidity costs, things like that.
And the second one would be the underlying assets for these guys are illiquid, right? So you’re typically looking at private companies or private debt or whatever. And if you’re hedging that with derivatives, which obviously can be margin called and are liquid products to back that liquidity mismatch brings up also certain challenges and implications.
So everything we do from the strategy we design to the way we report on Risk is customized for the private capital space.
So if you think, just to give you an example, like if you look at a typical private equity fund, they’re not really concerned about short-term volatility, they don’t look at things like Sharp ratios. They have their own kind of lexicon of how they approach performance, including Risk. And so everything we do is based upon that. So we’ll look at, for example, what’s the risk to your multiple or to your IRR, as opposed to just giving them a VAR number as just one example.
So I think, that’s really our key differentiation. We are very practical, we come in and we can deliver results, but also it’s very much based upon the needs of all of the private capital sector, which as I mentioned, is a very large sector and very fast growing sector. But it is to some extent still under-served in certain areas.
Boris: Kevin, I would like to hear your personal opinion. What is the commonly held belief in the market risk or the biggest misconception that you strongly disagree with?
Kevin: That’s a great question. I think in my mind is one very clear one, which I alluded to in the previous answer, which is the role of volatility. I think in conventional financial risk management, I think there’s a tendency to equate Volatility and Risk as being almost the same thing. Whereas, my view would be not only are they not the same thing, but in some cases they’re actually opposites and there’s a great quote by Nassim Taylor about you can’t have long-term stability without short-term volatility.
I think that’s a really powerful quote, which I always think about. I think that has a lot of far reaching consequences, both in terms of the macro environment, whether its of central banks micro-managing markets to almost compress volatility.
In the currency world, you could even look at something like the Euro. The one of the main arguments in favor of the Euro was to minimize trading friction by minimizing currency volatility for trading whithin Eurozone, but that had lots of unforeseen consequences. For some countries that was probably really good, but for others, maybe it created certain obstacles to economic management and then on a micro level, we see it all the time.
You see assets which are very stable, but what’s really happening as Risk is just being compressed and compressed and compressed until it blows up.
A really good example would be Swiss Frank a few years ago, where for three years it barely moved around 1.20 and then in one day it declined by over 40%, right? Because all that risk was being compressed and it was being hidden in effect because you looked at the volatility and you would say, there’s not much risk hier, but in reality there was a lot of Risk and some firms blew up with real serious world consequences.
I don’t mean to suggest that volatility’s useless as a measure. I don’t, I think we use it every day when we were looking at measuring risk for our clients. But I think the key is to first of all to understand the weaknesses and the second of all, don’t look at it as an absolute measure of risk. It’s one input, it does provide some informational value, but if you’re not careful, it can be misleading.
So I would say, yes, that’s probably the one often believed principal in risk management that I would disagree with.
Boris: So if we are just continuing this question and if we take a life of a risk manager, if there is one thing that risk managers should start doing right now that they are not doing, what would it be?
Kevin: So it’s a very interesting question. In my career, I’ve worked in different areas of Risk from working in corporate risk management, through to advisory for investors. And I would say the one thing that often, and that’s not going to say always, but one thing that often, I think risk managers don’t do enough of is thinking more strategically. And when I say strategically, I meet in terms of the business strategy of the investment strategy.
So if you look at Risk in a siloed way and you don’t try and relate it to the objectives of the business or to the objectives of the investor, I think that’s where risk management can sometimes either go wrong or at least not add the value that it potentially could. So that will be my biggest suggestion, I guess, in terms of what risk managers can often do better is think more like business owners or investors themselves and not get too compartmentalised in all of the technicalities of risk management of which there are many of course, but
Boris: Interesting. So if we take this question, but another way around, what they should stop doing now that they’re doing currently.
Kevin: I always think of risk management as an interesting blend of art and science. And I think sometimes within the broad risk management field, there’s too much focus on the science piece and not enough on the art. And by that I mean getting too focused on the models, getting the models right, getting the precision of the models and not enough focus on the bigger picture and contextualizing what they’re doing.
You are never doing risk management in a vacuum, right, you’re always doing it with the real world. So if you take the world today, there’s a lot going on in the financial markets, which is very unprecedented and therefore just applying the same techniques, the same approach is the same ways of measuring risk and ignoring the background, ignoring the context. I think that’s probably what risk managers should do less of, and it’s an easy trap to fall into because we’re all schooled the same way.
We all learn from the same books and what’s going on in the wider world is much harder. We’ve never seen some of the stuff before, or if you take, for example, monetary policy, we’ve never lived through an era like we’re living through now. And what could that mean for various asset classes? You’re not going to find that out in your model, no matter how calibrated you make it. And if you miss that big picture, then what’s the point of risk management?
And whenever we see big problems and going right away back to like Longterm Capital Management, for example, it tends to be situations where something changes and the old models aren’t working anymore and we don’t react quickly enough to that.
Boris: So we continue with the current market situation. What is your view on the market considering high money supply, that we have in the United States?
Kevin: Yes, I think, it’s a huge factor as a risk manager is to try and understand what’s happening. And more importantly, what could happen, obviously we don’t know what will happen, but we can make an educated guess as to what could happen. As you say it’s from a monetary policy standpoint, we are in a very interesting times, I read the other day, something like a quarter of all the dollars ever created were created in the last year.
And, what’s that going to mean going forward again nobody knows, but we’re seeing, I think really interesting occurrences in markets, whether it’s, crypto, whether it’s, things like SPACs.
Just general valuations, in the private equity world we’re seeing multiples of 40% higher than they were a decade ago. So you’re paying 40% more for your EBITDA than you were a decade when we started Validus all of these things, are interesting.
We don’t exactly know what they will mean going forward. It doesn’t necessarily mean everything will correct lower. At the beginning of the year, we always put together kind of our market outlook for the year. And as we were discussing the market outlook for 2021 we saw three possible scenarios for the markets.
The first one we call a benign reflation, which was pretty much the consensus view, I think at the time where there’s going to be in the back of the vaccines and the fiscal and monetary support, we’re going to see a recovery in markets and the Central Banks would be able to control the inflation and keep a handle on that.
And that was probably like the Goldilocks scenario, which still may occur. At the time,we thought that was one of the more likely outcomes.
The second outcome is what we call the market meltdown, which was a big correction against all of these valuations and so on. We didn’t think that it was very likely simply because of the degree of monetary and fiscal support that had already happened and it was going to almost certainly going to continue.
And then the third scenario that we came up with is what we termed the market melt up, which is similar to the benign reflation, except that the Central Bank isn’t able to control inflation.
And you would start to see all kinds of side effects of monetary policy spilling over, ultimately into inflation, but also rates pushing higher. And I think at that time, at the beginning of the year, we signed a 40% chance to the first scenario, a 20% to the second and 40% to the third. So we kind of equally weighted benign reflation and market melt up.
And I would say sitting here today, a quarter over of the year, I would say the probabilities have shifted a little bit more towards the market melt up scenario, partly because of what we’ve just been talking about.
Some of these really incredible moves, whether you want to pick crypto, but even in the real world, the lumber prices are up 400 percent, house prices in the US are up close to 20% year on year. This is pretty big, right? These are pretty big moves that we’re seeing. And we did see the 10 year didn’t get to 2%, but started taking up towards 2% before it came off a little bit, so all of these things, I think probably lead us more to the conclusion that the Central Banking fraternity is going to struggle to control what they’ve unleashed.
And that is going to have knock on effects across the markets, whether it’s in our world, currencies, rates and commodities, but also equities and so on. So I would say that it’s still a balance, I’m certainly not going to scream that we’re going to see double digit inflation in the next year but I think we’re going to be pushing higher, and that’s going to have some knock on effect across the market.
Boris: Are you also working with crypto?
Kevin: So we work in the fiat world at Validus, but we have a lot of interest in crypto. We actually published a piece a few weeks, maybe a month ago or so on why crypto matters to us because on the one hand, as you mentioned in the beginning, we trade 300 billion a year in derivatives, and we don’t tread a single dollar worth of crypto.
That’s said we think crypto is a really important factor to focus on from a macro perspective, both in terms of what it means for the monetary system. Basically I think, the crypto trade in some ways is a short of the current monetary system. It’s an expression of distrust. And if that distrust builds too far, it’s going to affect everything else. So, that’s, one important reason to focus on crypto and the other it has become, I would say, now a systemically important asset class in its own right.
You’re looking at a market cap of crypto, well over a trillion. Now you got institutional investors starting to get into crypto. And if you see a big sell off, let’s say, that’s not going to be in a vacuum. That’s going to affect other asset classes as well. So we don’t trade crypto yet. We have explored some potential, some interesting, almost theoretical ideas of how do you incorporate crypto into the private asset world.
But it’s very embryonic at this stage, I would say a very, very early days, but we definitely think is an important, we were very much focused on the crypto world as an important driver of macro for the foreseeable future.
Boris: Well, maybe last question, you’ve been a long time member of Global Risk Community. And I would like to ask you how can we contribute to the process of a better understanding of this complex world of risk?
Kevin: That’s a great question. People think in stories and in narratives, and one of my kind of pet peeves, but one of the things I always noticed about the Risk world is it can easily get very technical and it’s very quantitative field for sure.
And that’s fine, but sometimes, the message doesn’t distill down to something that people, the broader populace get their heads around.
So why is risk management matter if you’re a company or you’re an investor or you’re a pension fund or whatever? So I think, any kind of format or a forum like this, which can help tell stories about real world situations, people working in Risk and what they’re doing in the impact of their activities on society or whether it be on macro level or on a micro level within a company, the fact that I’ve developed this risk management innovation, how has it helped my company, or how does it helped my pension fund or whatever.
I think you’re in a great place to be able to do that with your network. You have the people that you talk to. So just turning those sometimes quite technical innovations into narratives that can help people understand the importance of Risk.
And it’s such an interesting field as well. I think sometimes it can be a bit of an abstract concept. As an entrepreneur and someone trying to build a business in Risk, one of the struggles that we had, if you are sitting in front of the potential client and trying to sell a risk management service, one of the challenges you have is an abstract concept.
If I’m going to try and sell you something that will cut your costs or increase your revenues, you understand that it’s easy, it’s tangible, but if I’m going to give you something that might reduce your downside in certain circumstances, that is sometimes more abstract concept. And it’s sometimes harder to tell that story, but I think it is a really interesting story to tell.
Boris: I don’t have any questions. So if you have any, is there anything that I forgot to ask you and you would like to add to our audience?
Kevin: No, I think it was really interesting to speak with you. I think if I’m going back to the very beginning its kind of funny from an entrepreneurship standpoint because the entrepreneurship and Risk Management, you can see them as almost opposites, right?
Because if you put your risk management hat on, very few people are going to go on to start a business because you are taking on so much uncertainty, so much volatility, so much risk. So I think being a risk management entrepreneur is a strange position to be in, but it’s great to meet with you and to be able to tell this story to the Risk Community.
Boris: it’s a pleasure. Likewise, I’ve been myself Risk consultant until 10 years ago, and then I started this project in the networking of Risk.
Kevin: Well, it’s great to see how far you guys have come in and we started, I guess, around the same time.
Boris: But we don’t have 60 people like you guys.
Kevin: Okay. But you have a very big network though. Very big network.
Boris: Thank you Kevin and I wish you great success with your company.