April 10, 2024
Lopsided Relationships:
As a follow up to August Wealth’s March Commentary, it is worth digging into the private equity industry and alternative investments generally. As with all investments, there are pros and cons. The discussion in this piece is not to make blanket statements about good or bad; it is meant to educate and shine a light on parts of the financial industry that investors should be approaching with caution.
Although much of the below may seem critical of the alternative asset management industry, that is not my intention. My opinions do not really matter; what matters is that investors understand the risks and costs associated with their investments. In fact, many investors have done well as part of the alternatives industry (me included). I would happily invest with the founder of the hedge fund that employed me, and there are other worthwhile funds for certain investors. They can be worth the fees if they produce risk adjusted returns and do so while potentially capturing returns in ways that buying and holding traditional asset classes do not (this can diversify wealthy investors portfolios). Additionally, early investors in venture capital and private equity, such as the recently deceased David Swenson from Yale endowment achieved incredible success with alternatives.
However, when significant money can be made, it often attracts individuals and entire industries where the ethics and skills are dubious. One ugly saying in the industry which sums up some of the lesser quality portfolio managers in relation to their investors is: “heads I win, tails you lose”. There is a significant element of truth to that. I have known or worked with quite a few managers and proprietary traders in my career where this mentality was employed to great effect. They built high profile (revered) reputations for making large sums of money, and if they lost large sums and were fired, those reputations helped them move on to the next opportunity. The alternative fund management industry can make even lifetime losing fund managers wealthy.
Here is a hypothetical example of how a hedge fund manager can win and the investors lose at the same time.
On a $250m fund, the 2% management fee ($5m) usually covers all expenses (salaries, offices, administration). Let’s say the fund makes 30% in year one equating to $75m in profit (30%*$250m=$75). The fund manager gets to keep approximately $15m of the $75m profit. All participants are happy with this positive result. But if that same manager loses the 30% the following year, the investors lose money over the two-year period, but the fund manager keeps the $15m plus the management fees in year two. The fund manager then has a choice:
a) Work to earn all the losses back for investors because there is no incentive fee earned . until losses are recovered. This is difficult to achieve.
b) Close the fund, and perhaps open a new fund with new investors. Keep the $15m.
c) Retire with the $15m in earnings.
Why advisors might pitch alternative investments:
Having worked on the institutional side of the financial industry for most of my career, I understand why financial institutions and their advisors would recommend “alternative” investments to their clients:
The fees are high, and this incentivizes advisors to sell investments in alternatives. Many advisors may not fully understand the risk associated. My thoughts:
Motivations matter.
It is challenging to pick managers worth investing in.
Picking outstanding managers that outperform benchmarks (risk adjusted returns) is essential to justify the high fees being charged.
The market is complicated right now. Investing in alternative managers can help us navigate all this uncertainty. My thoughts:
The world is always uncertain, always changing, and you must ask the right questions to give you a chance at navigating it to achieve goals within your risk tolerance.
We should also be wary of those in the industry who may be more interested in making money than about helping you achieve your goals.
Using “alternatives” to potentially mystify and make the business seem overly complex is a fear tactic. It’s not helpful.
Locking up investor’s money in illiquid investments is good business from the institutional standpoint. It provides steady cash flows for the institution because the investorcannotchangestrategy. My thoughts:
Locking up money and investments which cannot be sold during a market panic can solve for potentially harmful emotional decisions like selling at the wrong time (this is potentially positive).
Although this forces investors to take a long-term view (may be a positive), it also means you should expect higher returns for the illiquid nature of your investment.
Solving for human nature by assuming illiquidity risk (without the commensurate return expectations) may not always be appropriate. This is not a good enough reason to invest.
Most investors should avoid alternative assets altogether. Why?
I believe the industry has been granted more legitimacy than warranted because many pension funds and endowments have been large investors.
The private equity industry claims that their returns outperform public equities with lower volatility. I find these claims highly questionable “(see below)”.
The private equity industry claims that they can unlock growth potential from companies in which they invest because of their skills.
While there is an element of truth to this, I suspect it is a minor driver of returns compared to historically low interest rates in the economy.
I will give my views on each of these points below, but you do not have to take my word for it. Listen to what Warren Buffett has to say on it. From Berkshire Hathaway’s 2019 Annual Meeting:
Some Quotes from this meeting from Warren Buffett:
“.... the returns are not calculated in a manner that I would regard as honest.”
“.... If I were running a pension fund, I would be careful about what was being offered to me.” ... “it’s not a fair fight when a bunch of public officials are listening to people who really just get paid for raising the money.”
“When you commit the money, in the case of private equity often, they don’t take the money, but you pay a fee on the money that you’ve committed and of course you really have to have that money to come up with at any time, and it makes their return look better ...”
From Charlie Munger in that same meeting:
“What I don’t like about a lot of the pension fund investment (in private equity) is I think they like it because they don’t have to mark it down as much as it should be in the middle of the panics. I think that’s a silly reason to buy something, because you are given leniency in marking it down.”
“All their (private equity managers) doing is lying a little bit to make the money come in.”
Why avoid private equity?
Legitimacy through well-known institutions. Just because pension funds, endowments, or other institutional investors are putting money into a certain sector of the market, is not a reason to invest. It is a potential red flag. As one example of this, just consider how badly many pension funds fared in the 2008 financial crisis on AAA rated Collateralized Debt Obligations in the mortgage market. The financial industry is incentivized to make money; it is not incentivized to point out flaws in the system. I am not suggesting a comparison to 2008, but I am urging anyone considering locking up their money for 5 to 10 years to carefully consider the potential risks.
Higher Returns and Lower Volatility: The claim that private equity (PE) can achieve higher returns with lower volatility seems particularly dubious to me. Here’s why: According to Cambridge Associates, as of September 30, 2023, the Private Equity Index returned 14% net of fees and expenses over a 15-year period. This compares to an 11.4% return for the Russell 3000 index over the same period. Many investors tell me that they have achieved great performance on PE investments over this time, and that is likely because they only see their returns. They do not factor 2 important points:
Leverage: Almost all PE funds use leverage in various degrees. If we conservatively estimate they deploy $1.5m for every $1m invested, they are juicing returns by 50%. If one was to leverage the return in the Russell 3000 by 50%, the 15-year return would equate to over 17% annual return. If as Buffett suggests, the leverage is more like $2m for every $1m, this leverage would achieve a 22.8% return in the Russell 3000 (11.4x2) over that same period.
Volatility: Just because a company does not trade on the open market, does not mean its value doesn’t fluctuate (Charlie Munger makes this point), yet that seems to be the claim of the private equity industry. If a house is purchased for $1m and sold for $2m ten years later, that’s a good result without ever noticing how the value fluctuated over the period. However, if the house (an illiquid asset) needs to be sold during a market panic or an adverse personal financial situation, the current value will be found out, which may be unpleasant. I cannot understand the PE claim that these investments provide a lower volatility return stream unless of course you’re an ostrich with his head in the sand. Assets fluctuate, this is because there are few transactions on which to base a price. This may seem like a lack of volatility, but it is actually just a lack of information/liquidity. This is not the case in the world that I live and work within. No need to take my word for this either; you can read what Cliff Asness, founder of AQR Capital Management has to say on the topic: https://www.institutionalinvestor.co m/article/2bstqfcskz9o72ospzlds/op inion/why-does-private-equity-get- to-play-make-believe-with-prices
Superior Skills to unlock growth potential at companies. This claim has some validity. Finding the right companies to invest in for growth takes skill and relationships. This is valuable particularly for large family offices and institutions that may benefit from relationships which also create possibilities for direct investment in companies. These opportunities are not available on public markets. These are very long term and illiquid investments, and the economic environment matters a great deal more than “superior skills” in my opinion. Interest rates have been close to zero for much of the past 15 years. When there is no interest on savings, investors take greater risk with their money. To protect themselves against rising asset values and a declining currency (most assets are priced in dollars), investors are more likely to purchase all kinds of investment opportunities. This will tend to push the value of companies and other assets higher relative to the US Dollar. In such an economic environment, it makes sense to start a fund, raise as much money as possible, borrow as much as possible, and charge high fees on your growing portfolio. I believe that the private equity industry was built on a foundation of near zero interest rates. It has been a huge success, and I suspect that both smart and novice investors have performed well in this environment. Most of us tend to expect what was successful to continue to be successful; this is where investment mistakes are often made. I look at evidence and probabilities, and the story has changed:
a) The Federal Funds Rate is now at 5.5%. This is a nice risk-free return; borrowing money is no longer free. There is no longer the need to take greater risk on asset appreciation.
b) Positive cash flows for assets and companies matter because every year that you are not being returned cash, you are forgoing a risk-free (opportunity cost) return on that 5.5%. This compounds quickly (for or against you).
c) If invested in alts, you continue to pay fees and expenses which are compounding against investors.
d) Recent comments by federal bankers suggest that the recent inflation increase has concerned central banks enough so that going back to a zero-interest rate world is much less likely (even in a severe recession). This can of course change, but much of the PE industry will naturally be hoping this happens.
e) Holding risky companies or real estate assets in need of cash infusions (because they are not covering their debts) with a hope of lower rates is not really a strategy.
The Real-World Impact of Private Equity:
There are certainly efficiencies and economies of scale that can be achieved by private equity coming in and making decisions that reduce waste and increase the bottom line. The problem is that profitability is the primary focus. This can come at the expense of what I regard as important intangibles. Focusing on short term profit at the expense of long-term intangible benefits often result in worse outcomes. For example:
In the medical field. When a doctor’s office gets purchased, the human side of medicine, understanding the patient’s unique needs and biology can get lost. What seems more efficient for the business can be aggravating for the patient.
In our own field of investment advisory, what are the results of selling your advisory business to private equity? The owner/founder can make large sums of money by selling, but usually at the expense of:
Independence (what made them successful in the first place); now they work for a firm focused primarily on economies of scale and profits.
Non-equity team members lose jobs and/or the culture erodes.
Client outcomes are probably worse because of disruption to relationships. There is less time spent by advisors on clients because time costs money.
My Motivation:
I want to educate investors, to help them understand the risks and high fees that this industry charges. These can work against the probability of achieving financial goals, and in many cases, may not meet the needs of investors. If you are being sold these strategies by an advisor or a friend that has done well in the past, I urge you to proceed with caution. Especially in today’s interest rate environment where it will likely be more difficult for these types of funds to succeed.
I suppose this piece seems very negative about alternative investments, but that is because the negatives are not highlighted enough. We mostly hear about the incredible opportunities in private equity. Who wants to miss out on an incredible opportunity? I realize that I am trying to push water uphill because there is an army of salespeople trained to continue to push these products until the financial benefits of doing so dries up.
However, we are here to advocate for our clients and others interested in our services. It is important to point out the relative risks of these strategies vs. what can be achieved through solutions that are much simpler, lower cost, and potentially more rewarding for the investor.
Joe
i Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor. Stratos Wealth Advisors, LLC and August Wealth Advisors are separate entities.
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