Continuing my thoughts on how the end of the Financial Repression Era changes the rules…this week is for the CIOs out there, whether at insurance companies, pension funds, family offices, etc.
How do you need to think about risky asset classes differently now that there is, once again, a cost to capital? First, let’s review the winners over the last 15 years and why they won.
Private equity and venture capital have had a great run. PE used cheap debt to lever everything up and then watch multiples go up as a result of the cheap leverage. VCs used free money to create bubbles around every corner.
Hedge funds, for the most part, had a good run, even with some challenges. Many were able to ride the tech bubble and low rates made it easy to lever up their returns and grow their footprints.
Activist funds also did well but it was certainly harder to find targets when most stocks are going up and holders are happy with their returns.
Non-correlated assets like catastrophe risk or commodities generally struggled due to easier opportunities elsewhere.
Truly counter-cyclical asset classes like distressed investing were largely on the sidelines while credit funds were able to ride the Fed moral hazard wave where defaults were verboten. Risk arb funds, similar to credit, also benefitted from the permissive risk taking atmosphere.
We know past performance is no guarantee of future returns, so what should we expect from here? My predictions are also no guarantee of future returns, but I will do my best to assess where I think the way forward is smoother or more challenging.
I would not want to be in private equity going forward. They are hurt more than anyone else by higher interest rates and a weaker economy.
Higher cost of debt means they can’t lever up as much for new acquisitions. Their existing investments are at peak multiples predicated on cheap leverage. This leaves little cushion for any deterioration in operating performance and the Fed is no longer opposed to credit defaults.
PE had a great, long run, but their returns are going to have to mean revert here, if not lag the broader market.
The glory days for hedge funds arguably already ended, but they are likely to get worse before getting better. Hedge funds thrive on volatility. Financial repression was great for creating crises and subsequent rescues. Easy money allowed the tech and crypto bubbles. Macro often drove the market.
What’s terrible for hedge funds is markets that slowly grind higher led by boring large caps. When everyone owns Home Depot and P&G and Coke and Walmart, it’s hard for a hedge fund to outperform.
Also, as competition has increased in the hedge fund world, gross outperformance has contracted. Managers offset this by increasing leverage which was an easy choice when rates were low and investment banks were happy to lend.
That will likely change. This means funds will likely take added risk to try to increase their gross returns with predictable consequences – more mistakes, more outflows, and more failures.
While post-bubble funds have done well in the past – since the quality of investments rises – the challenge for VCs will be raising money from their LPs. Given the reckless investing of the prior decade, investors will surely be more reticent to write new checks to venture firms.
This will limit their ability to make new investments and lower their fee potential. While perhaps AI will prove promising enough to overcome these headwinds, will people really risk being fooled thrice (after crypto and web3)?
Additionally, the potential for exit from existing investments is obviously severely diminished with equity markets no longer ebullient. Many portfolio investments need to be rationalized (a nice way of saying sold for pennies on the $ or closed down) to preserve capital for those still worthy of future funding.
Boy, this is hard. Is there any place for a CIO to put new money?
You may know it as vulture investing. Vultures get a bad rap (they are essential for controlling disease) and so do vulture investors.
The problem for distressed investors of late is there has been little distress to capitalize on. They were all ready to scavenge when Covid arrived, but then Powell saved the economy and ruined their party.
But going forward…there are two ways opportunity is created for distressed investors. One is when companies take on too much leverage and can’t service their debt. Check. The other is when a bad economy hurts cash flow and companies need to raise money. That looks like it’s on the horizon.
So it’s setting up to be a great time to be a distressed investor. Normally they’re focused on buying companies out of bankruptcy, but this cycle they’ll probably get to buy a lot of commercial real estate at bargain prices too.
Long Only Funds
If I’m suggesting hedge funds won’t have enough volatility to drive alpha, then where will equity investors find it? Likely in boring long only funds.
Indexing is an option, but active managers will likely catch up. In particular, blue chip funds that are more focused on long term growth like in the 80s and early 90s are in a good position to have a new moment in the sun.
ESG funds, as I have shown before, are largely disguised sector tilt funds. They are long tech and short energy. That worked well last decade but is probably not as good a strategy going forward so kick those out of your portfolio. It’s not worth paying the extra fees.
Risk Arb Funds
Risk arb does great when every M&A deal is rubber stamped and valuations are high. They don’t do so well when the FTC is run by a zealot who wants to kill every merger or at least extend the review process for years (time is money in risk arb).
Maybe if there is a new administration in ’25 that will change, but risk arb is very high on the risk and very low on the arb these days.
ILS and Cat Bonds
How about those insurance securities? Surely they will come back in favor with higher reinsurance prices?
Probably not. A big part of the reason ILS boomed was the free money era meant traditional credit was overbought and allocators were looking for anything new and different that might have higher yields.
If credit markets are normalizing, investors will have plenty of opportunity in high yield or other more familiar asset classes, so they won’t need to stretch into places like ILS.
Also, too many investors are still licking their wounds and psychologically are unlikely to return, so it’s going to have to wait for a new group of investors to arrive to see big growth again.
Activists have certainly done well over the last decade or so and, while it seems they may have picked over every target, I suspect things are about to get better.
Why? Because previously they’d only been able to pick on laggards, as in companies that were doing OK, while their peers were doing much better.
Now, there will be absolute, rather than relative, underperformers. A lot of bad decisions get exposed when the tide goes out and acquisitions will need to be disposed, divisions sold, etc.
There will also likely be a huge push for cost savings as we are seeing in the tech world already. In an inflationary world without much growth, expenses are the obvious target and activists tend to lead those initiatives.
So even though their act gets a little wearying, I think the activists are just warming up and will have plenty of opportunity in the coming years.
Summing It Up
So there you have it. Cut your allocations to PE, VC, and hedge funds. Increase allocations to activists and distressed investing. I’m sure there are other opportunities I missed, probably in the credit world.
More importantly, look at everything fresh and think about why it’s worked and was it really a product of the macro environment we were in or was it truly secular strength? If the former, then it’s time to reconsider your allocation.