“I don’t do it for the money. I’ve got enough, much more than I’ll ever need. I do it to do it. Deals are my art form. Other people paint beautifully on canvas or write wonderful poetry. I like making deals, preferably big deals. That’s how I get my kicks.
Most people are surprised by the way I work. I play it very loose. I don’t carry a briefcase. I try not to schedule too many meetings. I leave my door open. You can’t be imaginative or entrepreneurial if you’ve got too much structure. I prefer to come to work each day and just see what develops…
It never stops, and I wouldn’t have it any other way. I try to learn from the past, but I plan for the future by focusing exclusively on the present. That’s where the fun is. And if it can’t be fun, what’s the point?”
The Art of the Deal, by Donald Trump with Tony Schwartz (1987)
The disparate treatment of institutional allocation to private equity and hedge funds has gotten a lot of press coverage over the last year or two. At Epsilon Theory, we published a brief called Locusts’ Lament discussing the glowing private asset narrative and the correspondingly dismal hedge fund narrative that you would expect as the relative allocations of large allocators to these areas move in opposite directions.
Research, consultants, social media and the press offer a lot of explanations for why institutions continue to make large – if mostly consistent with the last few years – allocations to private assets while approaching active liquid strategies with increasing skepticism. Poor hedge fund performance. Strong exit valuations. The benefits of infrequent marks-to-market on private assets. And, of course, there’s the reinforcement that comes from the fact that everyone else is doing it. These all coalesce into a sort of career risk argument for the dominance of private asset funds.
These are all true, to one extent or another. But there’s another factor at play, and I think it’s structural. I don’t think it’s mean-reverting. I think it is a meme.
Now, part of the confusion of this issue in the press is the result of a poorly presented understanding of how decisions are made at large asset pools. Most articles imply that individual portfolio managers and senior staff are making significant regular changes to the asset allocation of these pools. Take a look at this recent piece from AI CIO. Read the headline. Read the sub-header. Now read the article. Is CalPERS rapidly deploying a burst of allocations or shrinking its allocation to private equity? And how is that decision being made? Still confused after reading? Good. Me too.
What is important to know is that while governance models can vary quite a lot, it is rarely the case that PMs – and frankly, even the CIO – would have the authority to make decisions out of keeping with the general asset allocation plan. In general, boards set strategic asset allocation targets on an irregular basis, usually at the recommendation of a plan consultant OR the Chief Investment Officer OR some combination of the two. They also usually set guidelines within which the staff is delegated authority. Some boards delegate a great deal of authority. Some delegate practically none. Some boards defer heavily to the strategic asset allocation recommendations of consultants or the CIO, and some guard that prerogative jealously.
But if you want to understand, by and large, how big pools of capital make big decisions about how much of their plan will be allocated to private equity, venture capital, private real estate, hedge funds, alternative premia (and everything else), you must focus on the interactions that take place between the CIO office, the consultants and the board. This is, of course, the nexus most people refer to when they discuss all those career risk-related factors. But most of those factors will rise and fall with the relative fortunes of this asset class or another. There is another factor which matters all the time:
Asset owner boards are dominated by politicians, lawyers and businesspeople. Deal people. People for whom – like the Donald – The Deal is their art. Understanding the decision-making process of large pools of capital means understanding the deals! meme.
From time to time, it becomes fashionable to attack these boards as unsophisticated or unethical. Sure, you could find anecdotes of just about anything, including these dismal traits, but in general, this just isn’t true. Most of these politicians, lawyers and businesspeople are smart. Very smart. Most of them are honest. Very honest. I really believe that, although I suspect I’ll take some flak for it. And many of them are truly subject matter experts, but almost always in fields other than financial markets.
I have seen board rooms when a discussion of a global macro hedge fund or a managed futures fund comes up. I have seen board rooms during discussions of risk parity and alternative premia. I’ve seen board rooms during presentations of relative value strategies across asset classes. I’ve seen staff present very efficient quantitative strategies that can leverage securities lending to produce better-than-passive results. I’ve seen the recommendation of risk-based tactical allocation and rebalancing schemes. Even among boards consisting of blindingly intelligent founders of multiple businesses, successful and well-respected politicians and other community leaders and stakeholders, the eyes go glassy in a hurry. Many of the strategies seem impenetrable, and usually fall well outside of the comfort zone of the people hearing them. Good presenters have learned that their best bet is to keep it short.
Private investment strategies, on the other hand, are the most similar of anything an asset owner does to what most of the board members have done to make their own careers. They find growing companies in a niche that just need capital to put them over the top. They broker deals between companies to make a larger, more efficient business. They offer to fix operational issues in a business generating actual products and actual cash. They negotiate with governments and regulators to create value in new ventures. It looks a lot more like investing, it feels a lot more like investing, and in a lot of ways, it is a lot more like investing than what most more liquid alternative strategies offer. More importantly, it feels like deals! I have been in these board rooms, too, and it’s front-of-seat stuff. There is only one public markets strategy that produces similar interest: activism. There is only one other strategy of any type that offers more interest: direct, opportunistic and principal investments.
Expect more articles in the next couple years that look like this article from the Wall Street Journal today. Opportunistic and principal investments have been all the rage for years, and are expanding into smaller pools, too, because there is nothing that looks more like a deal than a large pool of assets buying – and sometimes operating! – an actual building. An actual airport. An actual farm or timber property or producing well. An actual company.
I’m not saying that all this is good or bad, although I have a lot of opinions. We’re on record saying we do favor being closer to cash flows and further from abstractions, so there’s a lot of the emphasis on privates in general and so-called principal investments in particular that we are very much on board with (although any asset owner who thinks they aren’t getting at least some adverse selection in the opportunities brought to them is either unserious or dishonest). I am saying that if you are in hedge fund sales, in the shrinking cap intro space, or a liquid fund manager waiting for that bear market that is going to pull big asset owners back into hedge funds and other active strategies in public markets, I think you may be waiting a very, very long time. The deals! meme is just that powerful, and I think you’d have to see a brutal cycle of underperformance before the dynamic with boards changes in a way that will allow the big, slow strategic asset allocation processes to come up with shifts away from these types of investments toward active liquid strategies. Oh sure, around the edges, there is still going to be some performance chasing at the strategic asset allocation level. But as a really big shift? I think we’re still years away. I could be wrong.
Now, if you’re comforting yourself that ‘alternatives’ as a category has largely – and thankfully – been replaced by categorizations of private equity into global equity allocations, private real estate into real asset allocations and hedge funds into multiple areas reflecting the underlying security exposures, and that allocations really aren’t explicitly shifted between hedge funds and these private assets any more, don’t. They are. I mean, of course they are, even if it’s done so indirectly now instead of directly. In the old days, private equity, real estate and hedge funds were all in a catch-all alternatives bucket, and we shifted between them. In the new days, those allocations are almost always split out into multiple categories, but the governing constraints and conventions (e.g. minimum acceptable allocations to passive liquid markets, risk targets, maximum feasible allocations to high fee products) lead us to the exact same outcomes. Yes, asset owners are still deciding between private assets strategies and active liquid assets strategies.
It also doesn’t help that mean-variance models and other tools used as part of the average strategic asset allocation process are garbage in-garbage out. Consultants and some CIO offices that are targeting higher necessary returns are increasingly anchored to the asset classes that these assumption-driven models like. Why? Because every strategic asset allocation meeting for the last 5 years began, and every strategic asset allocation meeting for the next 10 years will begin with something akin to the following: Well, to meet our real return targets with these assumptions, we’d have to allocate 100% to either private equity or emerging markets! Ha ha ha! Of course, doing that would be imprudent, but…
Yeah, ‘but.’ Because by this time, the conversation has been framed. And in hundreds of rooms filled with truly smart, truly ethical, truly honest and well-meaning people infected with the deals! meme, private assets will not just feel like the understandable and straightforward strategy, they will look like the right and sensible and prudent thing to do as fiduciaries. And for some, that may end up being correct.
But for anyone hoping for the long-awaited sea change back into most active liquid markets strategies? I wouldn’t hold my breath.
So active liquid strategies are losing retail money to passive investing (now, to be had, for free - uh-huh) and “sophisticated” institutional money to Private Equity and similar “straight forward” (uh-huh, again) deal-like investments. I agree, those dynamics are not short-term or cyclical.
Tangential to your point, hedge funds, IMHO, destroyed themselves as they (many, not all) didn’t market themselves as “hedged” funds - lower vol investments providing better risk-adjusted returns - but instead, at least until '08, sold themselves as wonder investments allowing you to tap into a super-genius person or super-genius blackbox. I guess Epsilon Theory would say they broke their own story / I’d say they ain’t putting that toothpaste back in the tube.
Maybe enough years of better risk-adjusted returns in down markets versus indices (or just better notional returns, a tautology for a true hedge fund in a down market) will help, but only so much. The real question is how long until PE breaks as there’s no chance it can work now that it’s the popular trade, excuse me, investment.
I’m curious if this retail focus combined with the corporate tax repatriation, which will be used for M&A in a similar deal space, will cause price inflation and decrease returns. Or it could lead to a short term increase in valuations and benefit these funds.
Continue the discussion at the Epsilon Theory Forum