When at the end of 2003 Tom Connelly told his partners at Phoenix-based KeatsConnelly that he wanted to leave the firm he had helped found, he simply was looking to pursue a new set of personal priorities. With his new firm, Versant Capital Management, he was hoping to create a lifestyle practice, focus more time and energy on investments, spend more time with his family in the Minneapolis area and get out of Phoenix during its semi-annual allergy seasons, when many residences and golf courses switch from Bermuda to ryegrass and back, leaving him ill with bronchitis.

KeatsConnelly had specialized in cross-border financial planning, addressing the complex needs of Arizona’s fast-growing population of Canadian snowbirds. The firm devoted much of its time to issues involving immigration, dual citizenship, cross-border taxes and estate planning, and Connelly was becoming increasingly interested in investments. For a while, it looked like Connelly’s plan for a lifestyle practice might pan out. He left KeatsConnelly amicably, taking with him about 20 clients with around $70 million. (To this day, he still recommends his old firm to foreign retirees seduced by Arizona’s balmy winters.)

A French word with Latin roots that can no longer be found in many dictionaries, the name “Versant” was the brainchild of Connelly’s wife, and it means to be skilled and well-versed. Starting a new firm in 2004 at 48 years old as the U.S. economy was emerging from a tech bubble and a terrorist attack might have seemed a daunting challenge for many advisors. But Connelly just wanted to spend more time with family and not deal with bronchitis twice a year. He bought a three-story home on the Mississippi River in St. Paul, looking to grow his lifestyle business in both cities.

Soon after, however, clients were finding him on a regular basis in Phoenix, where he enjoyed a stellar reputation, while expanding his firm in the Twin Cities proved an uphill climb. “I had a family name but not a business name” in St. Paul, he recalls, and the Minnesota state capital possessed a wealth of advisory talent. Clients for his advisory business in Phoenix were falling out of the sky, so in 2011 Connelly closed his stand-alone St. Paul office (moving it into his home to serve the handful of Minnesota clients he had).

By 2007, Versant had three employees and about $190 million in assets under management, and Connelly was about to get an institutional investor’s view of the worst financial crisis in 80 years. In late 2006, Arizona Gov. Janet Napolitano appointed him as a trustee of the then-$25 billion Arizona State Retirement System (ASRS), where he’s served ever since. (See related story.)

As an RIA, Connelly has always tended to be somewhat more conservative than most—it’s unusual for his clients to have more than 65% or 70% of their assets in equities, though there are exceptions. His investment philosophy might best be described as opportunist and contrarian with a value bias. “I think more like a Depression-era person than a baby boomer” who learned about investing in the 1980s and 1990s, he says.

During the late stages of the tech bubble, that meant many of Connelly’s clients at his old firm had between 30% and 60% of their assets in equities. Instead of looking at U.S. growth stocks, he was finding returns in beaten-down emerging market closed-end funds.

At Versant, this opportunistic style has led him to make small investments in gold, typically 2.5% to 5.0% of most clients’ portfolios. In the previous decade, Connelly viewed gold as a way to protect clients against the “Greenspan put” and soaring debt levels.

In 2007, Connelly read an article in the late Peter Bernstein’s newsletter about credit default swaps (CDS) by Tom Seides, president and chief investment officer of Protégé Partners, that startled him. “I decided that if I ever saw some large and/or discontinuous moves in CDS rates, I’d make some moves,” he recalls.

By the time equities began to tumble in spring 2008 following Bear Stearns’ bankruptcy, most Versant clients had less than 50% of their portfolios in equities. “I wouldn’t represent that I could do it again,” he says, chalking it up to luck. Call it what you want, but he sensed something was seriously wrong in the financial system. He had also sold a house in Phoenix in 2005 and spent the next 30 months renting an apartment before buying a big condo with room for his family in 2008.

Nonetheless, it was a harrowing year, even if Connelly and Versant clients were surviving better than most Americans. “Clients would come into meetings and ask how I was doing,” he says. “It was surreal.”

Starting in 2006, Connelly found himself sharing a large client with Elizabeth Shabaker, director of investment operations at Phoenix-based Inlign Wealth Management, an advisory firm formed by partners in the wealth management unit of the late Arthur Andersen & Co. With 175 clients and $2 billion in assets, Inlign probably was the largest RIA in Phoenix.

The mutual client, a successful real estate executive and CEO of a public company, was a general partner in her family limited partnership, which was managed by Shabaker and the staff of Inlign. At the same time, her personal money was with Connelly at Versant.

In early 2008, Genspring Family Offices, the multifamily office arm of Suntrust Bank, acquired Inlign. The two firms’ approach and cultures clashed sharply. Inlign embraced an open-architecture platform utilizing a cost-conscious approach to asset management that relied heavily on passive investment vehicles. In contrast, Genspring used its own internal investment team, including several proprietary hedge funds.

Shabaker recalls the two firms having detailed discussions about investment strategy before the merger. The agreement at the time was that the philosophy would be evaluated after the merger, and the partners would decide whether it made sense to run Inlign’s open-architecture platform in tandem with Genspring’s in-house strategies.

In the early part of the post-acquisition period, the merged firm ran on two platforms. However, efficiencies and scale proved a serious challenge in the Darwinian post-crisis era, and after much deliberation, top management decided Genspring’s platform would be the sole survivor. “We were told to get on board in 2010,” she recalls.

Instead, Shabaker and others, including former Inlign founder and CEO Mark Feldman, began looking for lifeboats. At about that time, their mutual client with the FLP introduced Shabaker to Connelly. Back in 2006, Connelly knew Versant lacked the infrastructure to service the woman’s FLP. “She knew I wasn’t happy at Genspring. She wasn’t either,” Shabaker says. “At that time, I wanted to find a place with the same core values and beliefs as we had at Inlign.”

So in July 2010, Shabaker moved her business to Versant. She wasn’t alone. Feldman would leave Genspring in September for another huge Phoenix RIA firm, Miller Russell, where he is now CEO.

Like others after an acquisition, Shabaker had suddenly found herself in an untenable position. Having preached the importance of tax efficiency and controlling expenses through passive investing to clients for years, placing them in hedge funds was antithetical to her philosophy. “They’d been pitched hedge funds for years at Inlign and we’d told them not to do it,” she says.

In retrospect, it appears amazing that senior management at Inlign and Genspring failed to foresee such an obvious conflict before consummating the transaction. After all, these were two multi-billion-dollar firms, not a couple of solo practitioners.

Shabaker’s clients included an Indian tribe and some other large families. After the introduction by the mutual client, Shabaker and Connelly discovered they were very much alike in philosophy, and their skills were also complementary. “On the investment side, he is one of the best in the RIA business,” she says. “I can put together an asset allocation plan, but do I want to be a CIO? No.”

She had a non-solicitation agreement with Genspring and had to turn clients away for a year. But the impact on Versant was immediate and dramatic. Connelly knew he was “crossing the Rubicon” and saying goodbye to his lifestyle practice. In 2008, Versant had about 60 clients and $191 million in assets. By the end of 2010, the firm had $316 million in assets, of which about $75 million came from Genspring. “He realized a lifestyle practice wasn’t very practical,” Shabaker says. “It was his legacy and it [ultimately] wasn’t good for his clients.”

Connelly himself has praise for the training Shabaker and others received at both Inlign and Genspring. “One of the reasons I hired Liz and others is because of the exceptional training they had,” he says.

Today, Versant has 90 families, about $620 million in assets and 15 employees, five of whom are Genspring alumni. Much of the subsequent growth has been organic as Connelly and Shabaker have onboarded some large Arizona families. In 2013, Shabaker became a Versant partner and now serves as chief operating officer.

With her expertise in family governance, Shabaker has provided the firm with another dimension many RIA firms lack. Both Connelly and Shabaker serve as adjunct faculty at the Institute For Preparing Heirs. Shabaker acknowledges that Genspring offers an excellent array of tools for family governance and next-generation education. That was one reason she and other ex-Inlign professionals hoped they could find “a happy medium” with Genspring.

Working with very successful affluent families over the years, Shabaker has found a number of problems that keep resurfacing among different families. “Parents, or the first generation, often create elaborate trusts, but the reason why is never explained to the heirs,” she says.

When family dynamics are introduced to the equation, it can be a recipe for misunderstanding. As modern families become more complex with multiple marriages and different sets of children, even sharing how the money was created can become an issue, she says. “If there isn’t trust or communication and you add a business” into the situation, problems can be expected to proliferate.

Facilitating family meetings is one way to pre-empt future conflicts. Shabaker tries to open a dialogue among family members to head off potential crises. “Most people wait until there is a trigger event and no one is prepared,” she says.

In trying to get clients to think about their wealth, “it’s about way more than the money,” she continues. “It’s about legacy, health, community involvement, the family name and family unity.”

One aspect of working with affluent families that Shabaker finds intriguing is “how people in the same family are so different.” That explains a positive trend she sees emerging in estate planning. “You are seeing more values-based trust language so the children aren’t penalized for making a values-based career choice,” she notes.

Most of the firm’s clients are business owners who either are running or have sold a business. That’s one reason Versant’s conservative investment approach resonates with their client base. Clients want to keep their money.

Since the financial crisis, Versant has found some new investment opportunities for clients in a closed-end Ireland fund, along with allocations to some municipal bond funds that use catastrophe bonds. The firm also used the Third Avenue Value Fund as a way to play the distressed debt and real estate markets. More recently, new investments include small allocations to Greece and Eastern Europe.

As Versant enters its second decade of business as a firm this year, Connelly finds himself wrestling with many of the same challenges as other RIA firms that are growing fast but hardly huge. For a firm with $620 million, Versant has a small head count of 13, but that is partially attributable to the high net worth of its client base. Challenges include managing growth, attracting new clients and developing its professionals. If the last decade is any indication, those hurdles should be surmountable.

A Tour In Public Service
Many advisors are serious about investing. Most of the larger RIA firms have at least one or two CFA charter holders running their investments. Although some may be serious, they may not possess Tom Connelly’s insatiable curiosity.

In late 2006, Connelly turned 50 and embarked on an experience in public service that gave him a perspective into the world of institutional investing that few RIAs have enjoyed. A friend and client recommended to Gov. Napolitano that she appoint Connelly to the Arizona State Retirement System. At the time he formally became a trustee in early 2007, Connelly was a registered Republican. Today he is an independent, but takes a measure of pride in being appointed by a Democrat and being reappointed twice by Republican Gov. Jan Brewer. Arizona trustees receive $50 a meeting, but Connelly waives the fee.

Connelly clearly finds investing fascinating. He regularly attends CFA Institute meetings and is a member of the “Q Group,” formally called the Society for Quantitative Research and Finance. Members of the Q Group include Nobel laureates like Harry Markowitz and William Sharpe. Connelly jokes that among fellow Q Group members he is “a math dilettante,” but admits he reads widely to satisfy his innate curiosity.

Others are more generous in their descriptions. Paul Matson, executive director of the retirement system, calls Connelly one of the most talented academic thinkers outside of academia. “In my opinion, Tom could easily teach investments in any university in the country,” says Matson, who would eventually name Connelly to chair the system’s investment committee in March 2009, a propitious time if ever there was one.

If Versant’s business was holding up during the financial crisis, the retirement system was experiencing rocky times. In 2007, it was managing roughly $25 billion, though that number was starting to bounce all over the place. The state pension fund was employing an equity-rich strategy going into the crisis with approximately 45% of its assets in U.S. equities, 20% in international stocks, 30% in U.S. fixed-income and 5% in real estate.

Matson describes the system’s asset allocation as “not quite typical,” but hardly out of line with other states. “It was equity rich, real estate light and U.S. dollar heavy,” he recalls. That gave the retirement system one disadvantage and two advantages. Moreover, the equity markets were far more liquid than real estate.

As markets began to unravel, the system decided to make major allocations to real estate and private equity. Fortunately, fate was going Arizona’s way. These two alternative investment mandates were only 25% funded when the crisis exploded in September 2008, so it was able to purchase real estate and private equity assets at bargain basement prices over the next 18 months.

The retirement system receives presentations from the world’s leading asset management firms. That means directors get a sneak preview of the latest strategy du jour in the institutional space, strategies like imported alpha and risk parity that typically take 18 months or more to make it to the RIA world. “It’s fun to listen to a presentation from [Oaktree CEO] Howard Marks, [BlackRock CEO] Larry Fink,  [Bridgewater founder] Ray Dalio or [AQR CEO] Cliff Asness,” Connelly says.

Many of these top institutional investors are self-made billionaires but, while they are obviously smart and possess very different personalities, they rarely exhibit hubris, having been humbled by the markets at least a few times in their careers. “You generally don’t find arrogance at the top of very successful organizations,” Connelly says.

Though Versant itself happened to enter the financial crisis light on equities, Connelly acknowledges that they were not seriously overpriced, especially compared with past collapses in 1987 and 2000. By early 2009, they were downright cheap. Yet most of the advice the Arizona retirement system was getting from the institutional consulting universe was to move into alternative investments like hedge funds.

“There was a lot of pressure to get into [vehicles like] long-short hedge funds,” Connelly recalls. “We resisted, stayed in equities and reinforced it a little bit.” The move paid off handsomely, but at the time, it was hardly clear. “We didn’t know if the Fed strategy would work, but we decided the horse was out of the barn,” he says.

What the retirement system board was hearing from the institutional consulting world was very different. “We were told to underweight equities because returns would be low and risks were high. The world was saying that there was no way you could make a decent rate of return in stocks over the short term because returns would stay low,” Matson recalls. “But we thought corporate profits would recover fairly quickly. We were told risk parity was the new strategy that would outperform [in the post-crisis environment]. And we were told to overweight real estate before the crisis and underweight it after the crisis.”

The ASRS board also maintains a position in inflation-linked investments, and at this time Matson says they were hearing they should expect hyper-inflation or “at least high inflation.” Serendipitously for the state’s employees, the ASRS did none of the above. Matson, Connelly and the ASRS board also resisted the hard sell from some very smart people pitching hedge funds. Matson admits they have “a corporate view that is not supportive of hedge funds, but that is not to say [the funds] don’t work for other [investors].”

However, as fiduciaries, Matson, Connelly and other trustees are compelled to listen to a wide variety of investment views, including those diametrically opposite of their own. The screening process is intensely meticulous, and the fund typically selects only one out of three to five managers and/or strategies that it considers after rejecting an even larger number of institutional managers.

Hedge funds have several drawbacks. “We’re not comfortable substituting beta for alpha returns,” Matson explains. “Beta returns are more fundamental and stable and are driven by the economy.” He adds that most hedge funds have a benchmark of zero, which ASRS directors believe is inappropriate for long-term investments. Furthermore, Matson says the high fees associated with hedge funds and the level of transparency, which “on average is marginal,” were reasons enough to stick with their long-only stance. For his part, Connelly believes it is hard enough for a long-only manager to deliver alpha, and that much harder to do so going both long and short.

After being appointed chair of ASRS’s investment committee, Connelly, together with Matson, quickly began a push to change its governance structure. “Tom was a champion” of two changes in governance, Matson notes.

Trustees often sat on different asset-class committees and they decided to terminate that practice. “We had issues internally in terms of trustees involved in the decisions, frustrating the manager selection process,” Connelly says. “The big responsibility of the board was to do oversight, but they couldn’t stand back and hold staff accountable if they were involved in the process.”

Another issue that Connelly found particularly frustrating during the financial crisis was that there were remarkable investment opportunities, but the system followed cumbersome, bureaucratic procedures that forced the ASRS to conduct months of review before capitalizing on bargains like distressed credit that were omnipresent in early 2009. They streamlined the process so the pension fund could move faster when opportunistic situations arose.

“Tom is a strong practitioner who can make his case,” Matson says. “He is also a professional diplomat. He can debate, he can listen and he can incorporate practitioner and academic research into prudent decision-making. In that respect, he is an outlier.”

Like Matson, Connelly acknowledges that a $35 billion fund with responsibility to 550,000 plan participants needs to hear outside opinions that are at odds with their own. “I solicit opinions from staff, consultants and other investment professionals,” Connelly says. “If I have a real problem, I might take them offline. Things don’t always happen my way and that’s a good thing. You don’t want people to be bullied or hog the spotlight. Part of the fun is hearing different ideas and perspectives.”

The ASRS is on a June 30 calendar year, but since Connelly started chairing the investment committee the returns speak for themselves. In the calendar years ending June 30, 2010, through June 30, 2013, the fund generated returns of 14.9%, 24.6%, 1.3% and 13.1%, respectively. For the 10 months through May 2, 2014, it was up 14.3%. Compared with other pension funds with more than $1 billion in assets, the ASRS ranked in the top 8% over the five years ending December 31, 2013, and in the top 5% for three years. At the present time, Matson estimates the fund is about 77% to 78% funded, modestly above the median.

Today, Matson says the vast majority of global markets are fully and fairly priced—with two exceptions: private debt that, for whatever reason, is too big for most banks and too small for Wall Street banks to syndicate in bond offerings and certain classes of European equities, typically in the small-cap and value sectors.

Matson credits Connelly for convincing other trustees that tactical decision-making and focusing on fundamental valuations are the way to outperform. “Fundamentals always come back to drive prices,” Matson says.

Experiencing blistering growth at Versant while finding intellectual stimulation through public service at the ASRS has been an exhilarating experience for Connelly. He has learned some invaluable lessons from viewing the investment world through the lens of a public pension fund.

Probably his biggest surprise is the high caliber of the personnel at the ASRS. Many are CFA charter holders who are keenly intelligent and often more sophisticated than most advisors. They may lack an entrepreneurial bent and be attracted to the security that comes with public service, but Connelly says their abilities are underrated by other investment professionals.

Another takeaway for Connelly has been the process that institutional investors use to vet an investment, particularly in the alternative arena. The ASRS frequently hires more than one consultant and spends $80,000 or more before allocating assets to a private-equity fund or real estate property.

Connelly acknowledges that the literature on pension fund and endowment performance is agnostic. Some outperform, others don’t. Still, “an independent RIA doesn’t have access to the same kind of information or analysis,” he says, questioning how even a very large RIA firm could ever devote the time and resources to conduct a thorough analysis.

Public pension funds like Arizona’s are required to disclose voluminous amounts of information listing all their investments, while frequently publishing meeting minutes, sponsor presentations and consulting reports examining both liquid and illiquid assets. Connelly maintains that curious advisors could greatly expand their understanding of the investment world by researching this alternative universe. “You’ll never know what you’ll find if you poke around,” he says.

At a time when many public pensions face funding crises, Connelly’s venture into public service has turned into something far more significant than simply another smart RIA exploring his curiosity. It has been a chance to make a difference in a larger universe. “I’ve gotten to meet a lot of wonderful people,” he says.  “It’s been a privilege.” —E.S.