Preparing for chaos: the Geneva lesson

I attended an event for fund manager CEOs in Geneva last week. Yes, I was in disguise. Not only are CEOs dealing with multiple challenges, but they are also navigating unprecedented ‘change’, the speed of which is accelerating. Accenture’s Global Disruption Index has jumped 200% from 2017 to 2022 vs only 4% from 2011 to 2016. ‘Chaos Management’ has entered the lexicon, and attention is now being paid to ‘preparing for the unexpected’ where greater emphasis is placed on speed, flexibility and liquidity. Cash is King, especially in a crisis. Despite all these challenges, there’s no burning platforms or sense of panic. Not yet anyway. A few attendees questioned whether their assets continue to essentially do ‘what they say on the tin’ and the only real grumble – other than the usual pressures and considerations around ESG, T+1, inflation volatility and geopolitics, etc. – was with regard to the current challenges facing private equity.

Sock horror

The memory of my father wearing off-white socks with Birkenstock sandals still haunts me. I’m scarred by it. To me, it’s the fashion equivalent of using a fork to eat soup. It. Doesn’t. Work. It’s for this reason I could never own Birkenstock (BIRK) shares and didn’t participate in their public listing. Irrational, I know. But also a rare example where basing decisions on emotion might produce a good outcome, given the underwhelming IPO. The shares were -18% at time of writing. Not a great sign of my father’s fashion. Nor, is it for PE hoping for public market liquidity over the coming months (see above: grumble).

There’s margin in mystery

Now, in fairness, alternatives continue to attract significant share of mind. Some US CEOs argue it’s where they concentrate their active decision-making, for it’s hard to find edge in US equities, which have become a single decision market: namely, how much of the Mag-7 to own. There remains an interest in infrastructure, selective real-estate and increasingly, private credit (more below). Non-correlated returns are being sought in areas like life insurance, litigation finance, sport and renewables. But the outlook for traditional PE, especially VC and buy-outs, is a little more uncertain. Broadly speaking, this year will likely be the first year the asset class has under-performed – an outcome that brings the fee structure into light. And, as many institutional investors find themselves over-indexed (thanks to ‘denominator effects’) the industry is now courting retail investors. Wherever you have retail you have regulators. As we, in public markets know all too well, there is downside to democracy. It’s called transparency – a deflationary force – that can remove the mystery, and therefore the margin, in manger returns.

Canary or the gold mine?

With the IPO market stuttering (see BIRK and CART, while the jury’s out on ARM) alternative funding avenues are being explored by General Partners (GPs). Continuation funds and secondaries are common and we are starting to see more securitisation, either of Limited Partner (LP) commitments or against the portfolio itself – a practice known as NAV lending. Last year we saw CFOs, collateralised fund obligations, where collateral of varying risks are bundled together, given an A-rating and sold to retail investors. As the image of my father’s socks-with-sandals still burns in my mind, so too the memory of CDOs in many investors. But we must be careful not to extrapolate here. The issues seem as much about price as liquidity. But it is fair to say, as Ted Seides has in his article, NAV Loans: Canary or the Gold Mine, that at the very least these are signs that the ‘oxygen’ is getting a little thin, it’s “late-cycle” and that these developments could be adding “uncompensated risk to LPs”. But if you are interested in areas where there’s still plenty of oxygen, where regulatory scrutiny has peaked, valuations have troughed and competition is low (but growing), can I introduce you to the Japanese, UK, or Brazilian Stock market? As I’ve mentioned before, it might be time to buy those shares, before PE does.

Be smart, be PC

As an industry, PE over-indexes on intelligence. It’s why I avoid PE execs when playing chess, but include them in my pub-quiz team. I also keep an eye on what they are doing with their own ‘smart’ money. Well, for starters, many are busy hoovering up UK equities. Many others are transforming into private credit funds, which tells you where they think we are in the cycle. Take Apollo, whose private credit (PC) unit now manages 4x its buy-out division, the once cornerstone of its business. And why not? There are few free lunches in investing save the meal left by a distressed seller. And being accustomed to providing leverage to individual companies, these lenders can now issue decent double digit senior paper at low LTVs backed by a diversified portfolio of companies. That’s enough compensation to clear the burden of inflation volatility and ride out the cycle. It’s also highly attractive to those enormous pension funds entering a decumulation phase of retirement. And in the worst scenario, the borrower defaults, the PC firm gets an asset (one they know well) at a better price and better time in the cycle (see above: ‘smart’).

And so, for those that can, it might pay to become a little more PC.

Role play

A coach will often pick players to perform a certain role in order to execute a game plan. Failure to ‘do their job’ and they’re often dropped. It’s similar with investing. A lot of managers I meet are questioning the role certain assets play in their portfolio, and whether those assets still perform that role in a changed environment. Not to pick on PE again but seeing as it’s topical: PE has never been primarily about diversification (the clue’s in the name) but more about generating higher and ‘smoother’ returns. Given where we are in the cycle (late), future return assumptions become mathematically lower. And if regulators get their way (think more frequent measurements) smoother return profiles will likely become a thing of the past. In this scenario, PE will still have a role to play for investors of course, but it likely becomes more one of providing ‘access’.

What about equities?

Yes, always equities. They are a best-performing asset over time and offer the highest real-returns. Only commodities perform better during times of inflation. But be mindful of starting valuations, price always matters. Some investors are growing concerned US equity markets could be range-bound for an extended time. In such periods, returns are generated through active stock picking, more so than passive index tracking. The closest analogue was the period between 1968-82, where multiples compressed from high levels but the index started and finished at pretty much the same place (real returns got crushed). Many international equities outperformed and there was added premium placed on selling-discipline. But yes, you want equities – especially good-value equities like those in the UK, Japan and EM (Brazil).

And bonds?

That ‘safe’ asset that provides ballast to equities? Well, they haven’t really done their job, if assuming that job is diversification. They’ve been positively correlated to equities recently – even during times of market distress. We just had the lowest PMI since reunification in Germany, and bund yields went up and implied downside volatility is now higher than gold (perhaps a safer reserve asset?). In fact, bar the first two decades of the 21st Century, bonds have tended to be positively correlated anyway. So it can’t just be diversification – it must be something else. Capital gains perhaps? That’s certainly worked for the past 40 years when it’s never really been wrong to own bonds, until 2020 that is (since then TLT is -46%). And now, with demographics, decarbonisation and deglobalisation, I’m still not sure? Perhaps range-bound, at best, with gains concentrating in those active investors with a good selling-discipline (a what?). What about income? It’s true, short duration looks attractive, especially for cash, a different topic. But longer duration bonds still do not, I believe, adequately compensate the risk of mean reversion, be that as it relates to term premium, TIPS and of course, inflation. Yields arguably are still not high enough to compensate for the corrosive effects of inflation volatility. Above 5% on the 10 year and I would start to consider them again. But then, only for a trade. Here’s why….

10 yr. US Govt. yields back to the average for the first time since 2007

Source: GFD, Deutsche Bank

Volatility’s wild ride

Few things cause as much debate as inflation statistics. And yes, if you take out rent, energy, food, car prices, transportation, education, durables, nondurables, utility costs, child care, medical care and ammonia (which has just doubled in price)…inflation is back to normal. But things are not normal, unless by normal you mean pre-1980, which no one can easily remember. Inflationary forces remain deeply rooted in the system: two major wars, a surge in deglobalization trends, anti-immigration and a US economy that is running deficits at a time of full employment. We have under-invested in our capital and mineral stock. We assume labour strikes are cyclical, but what if, as the demographers suggest, we are about to retire twice as many tradesmen and women, train-drivers and miners than we have graduates entering those careers? Can AI spot weld? I doubt it. We are already short these workers just as the world embarks on its largest – ever – construction project. And look, I could be wrong. We might get back to 2% inflation and stay there. Equally we might experience disinflation, deflation, stagflation, or even hyper-inflation! The reality is, all are possible and so we can expect more volatility in the most critical component of every supply chain: interest rates and the money supply. And because of that, we as investors must demand more from our assets in future than what they’ve delivered in the past. And for that we need more comfort – most often found in lower valuations and higher starting yields. Sing out if you have trouble finding either…

A return to normalcy?

Rising rate volatility will increase inter-asset dispersion and force us to consider new asset classes in order to diversify portfolios. There must be more focus on ‘real returns’, with a push for managers to consider absolute or real-return targets (CPI+) in favour of peer/index benchmarking. While everyone agrees inflation is a risk, few are eying commodities – which is baffling given they are negatively correlated to bonds, lowly correlated to equities and are a statistical hedge against inflation. It seems asset owners prefer buying inflation protection through derivatives – an asset once deemed ‘risky’ that is now being employed by the traditionally ‘risk averse’. That might change as folks start to realise materials are not only essential to the world we inhabit today, but also the greener world of tomorrow. A world where our beer tastes better and in which we can rely on nature to harden our nuts prior to the Conkers World Championship. And maybe, a world where sandals are worn without socks. For only then, can we say we have returned to ‘normal’.

To end with a statement of the obvious, the movements of markets seem of trivial importance compared with the value of human life. I always struggle to provide market commentary in times like this, so I write with thoughts and prayers for all friends and colleagues impacted by recent saddening events in Israel.