The quarter was a strong one for our private equity heavy portfolios, the reasons of which are highlighted in our quarterly reports.
Public equity markets have also been exceptionally strong, and the pundit debate seems to remain centered upon: whether inflation is transitory or structural; whether the upcoming Central Bank bond-buying cessation (tapering) and upcoming rate- hiking are fully priced into markets already; and, whether the new delta variant of COVID-19 will be a natural brake on accelerating and hot global economies.
The “all-in equity” trade is, of course, gathering its skeptics, but none of them have come forward to suggest a better alternative. Even the former but now retired (read: does not have to talk his own book anymore) Bond King, Bill Gross, has come out and said, “bonds are ‘investment garbage’ amid low yields”.
PUTTING MARKET DRAMA INTO PERSPECTIVE
The constant newsflow pertaining to the markets is endless. The volume and ubiquity of global news, financially relevant data, and opinions, seems to have swollen to the point where it is almost impossible for even the most attentive and intelligent human to anticipate and remain sufficiently informed to make correct and dynamic judgments on portfolios. We are all constantly bombarded with “noise storms” that contain salient and relevant matters but often contain volumes of (mis)information that obscures financial waters and makes navigation very difficult during media-heavy hurricanes coupled with extreme NAV/ price volatility.
Looking beyond the information “noise storms”
For these reasons, I try to reduce making lengthy comments on the periodic news allegedly affecting the public markets because I don’t want to add more commentary to an already abundant supply of viewpoints. Rather, I try to add a perspective on public and private market volatility contributors, frame the issues, and outline a rationale on when to take action on portfolios and when to remain patient and stay the course.
Volatility storms in recent history
Fortunately, I have had the benefit of many distinctly different perspectives on financial market navigation throughout my career. In the past, many “volatility storms” were alongside legendary financial gurus in the business, both on the PE side and the hedge fund arena, but also amongst astute and wise principal investors that I worked for. The major storms included the equity crash in October 1987, the slow-burning meltdown of the Savings and Loan industry of the 1990s, the melt-up of the first wave of the internet- led bull market of the 1990s, the Asian financial crisis of 1997, the dot.com bubble burst of 2001, the “death
valley” and capital shortage period for Tech in 2001- 2004, the global credit crisis (“GFC”) of 2007/8, the EU/ Greek bailout crisis 2014/15, the surprise referendum of Brexit in 2016, and more recently the Q1 2020 Covid-19/Lockdown crisis.
Over a seemingly tumultuous 33-year period, US equity markets were up 17-18 times
Throughout these significant storms were, of course, plenty of small temporal volatility inducers (taper tantrums and other rate hike / earnings fear factors, for example). Still, there has been a backdrop of continuous quantitative easing, five different heads of the US Federal Reserve, seven US presidential administrations, and an innumerable set of disruptive technology developments that catalyzed massive structural industrial transformation. Over this period of approximately 33 years, including all the aforementioned drawdowns and “storms”, the US equity markets are up by 17-18 times, not including dividends, with the technology-rich NASDAQ having a slight edge over the S&P 500.
Evolving roles lead to different thinking
Early on, as a private equity investor, I had the luxury of being able to mostly ignore the noise in the public markets and remain bottom-up and or company/ industry-focused. Then, as an allocator to a multitude of hedge funds, where public market volatility was both a source of return but also a risk, I was drawn in intellectually to pay attention to the macro news events and synthesize the noise from the real drivers of returns across a range of investment strategies. Then, as a CIO for a predominantly retail-oriented private bank, it required continuous advice/guidance through both minor and major periods of news, or illiquidity-induced turbulence, to pacify easily unsettled clients as well as provide confidence to more aggressive and opportunistic oriented clients.
THE VIRTUE OF “STAYING THE COURSE”
Having been through many large and small drawdowns, it has reinforced the virtue of not reacting when fear or greed is elevated, to “stay the course” and to build protections against emotional interference with ones’ portfolio. A “stay the course” orientation is not a profoundly distinct statement but maintaining such discipline is easier said than done, especially if one has liquid, easily traded instruments in the public markets.
Questioning conventional truths is best done from another vantage point
I suppose I have oriented my public market temperament to be that of a private equity- oriented investor. But having been on both sides of both public and private markets and having lived through volatility in each, I have started to question certain conventional truths such as whether private equity is actually more volatile than public markets or if this public market volatility is overstated and manufactured and influenced by the media. Or further, whether the illiquid nature of private equity contributes to superior compounding. After all, it affects the behavior of the managers of companies in private settings and the investors’ degrees of patience, and hence their holding propensity through volatile moments.
We all know that the media is driven to get your attention via dramatic headlines or clickbait. Furthermore, the financial services industry is incentivized to create dramatic price volatility to stimulate turnover.
One of the virtues of private equity that used to be asserted was that it was a less volatile asset class than the public markets. However, it did not take long for the critics to come forward and note that, just because such price volatility is hidden, and under the opacity of infrequent reporting, this does not mean that it is not there. Private equity proponents fired back and noted, “how can a perfectly healthy public company with strong and diversified earnings stream be “valued” sometimes plus or minus 20% from one minute to the next simply because of the volatility in moods and liquidity of remote uninformed shareholders in the public markets?” As far as I know, this issue remains largely unresolved and will probably remain debated and studied for years to come.
At this point, I want to highlight that “price” and “value” are not the same thing. The most remarkable quotes on this distinction are from Oscar Wilde.
“The cynic knows the price of everything and the value of nothing.” “A sentimentalist is a man who sees value in everything and doesn’t know the price of any single thing.” – Oscar Wilde, Lady Windermere’s Fan
The peril of confusing price and value
I believe that business ”value” creation is non-linear over time; it can correspond to signing material contracts or losing them, creating new products, and a whole array of dynamically changing fundamentals in a company’s life. This “value” accretion itself can progress along a line independent of the “price” associated with it, and of course, it will be highly subjective and variable between market participants. I have come to realize that public market “prices” are often much more volatile than the probable long- term “value” progression of a company. Having seen the frictional damage caused by chasing returns at the top and exiting (by choice or force) at the bottom of market capitulations has strengthened my views of the merit in maintaining one’s discipline and not to lose sight of the long-term goal and the power of compounding. This, of course, aligns with a preference for equities and private equity strategies, more specifically as an asset class with a long duration and hence the ability to capture the greatest benefits in the power of compounding.
Cliff Asness, the respected CIO of AQR, a USD 143 billion global hedge fund, has also posed similar questions on the relevance of volatility in public and private markets and discussed it in a 2019 paper published by AQR.
“What if many investors actually realize that this accurate and timely information available in public markets make them worse investors as they’ll use that liquidity to panic and redeem at the worst times?” “What if illiquid, very infrequently and inaccurately priced investments made them better investors as essentially it allows them to ignore such investments given low measured volatility and very modest paper drawdowns?” – Cliff Asness, CIO AQR
The maintenance of a long duration perspective would also potentially explain, in part, Warren Buffett’s success as an investor who has always publicly touted the idea of being contrarian and enforcing/embracing a mentality of buying great companies and holding them “forever”.
Growth-oriented private equity is intrinsically long duration
This is essentially one of the central tenets of private equity investing. It is especially the premise around growth-styled private equity where the philosophy is to buy into growth themes (a very long duration strategy) of companies backed/run by entrepreneurs that are strongly aligned owner-operators and supplemented and governed by knowledgeable and specialized private equity owners. This match between the duration of the investment strategy and the duration of the investor’s expected holding period is following one of the most important maxims in our business, and that is to match asset and liability/ funding duration.
Innovation-rich investment strategies require a patient and “get ready for volatility” attitude inherent in this type of investing. This attitude sets one up to have forced patience and ensures discipline to power through periods of natural setbacks.
THE SECRET TO LONGER-TERM SUCCESS IN PRIVATE EQUITY INVESTING
I have come to hold the view that once investors are adequately prepared to meet their near-term liquidity needs in life, they can set aside long-term assets into long duration strategies. This approach, in turn, enables them to capture the most appreciation potential by staying the course and riding patiently in private equity.
If you know that the ride you (and your investment) will be on is likely to face turbulence over time: wouldn’t it be safer to be “strapped in” to the roller coaster with a seat belt (i.e. illiquid)? Wouldn’t it be better to be prevented from getting thrown off or emotionally shaken loose at the sharp turns of (inevitable) downside volatility?
We subscribe to this viewpoint and have built longer-term innovation-rich growth strategies with the protective features and benefits that accrue via private equity approaches.
CIO Commentary – Second Quarter 2021
by David Pinkerton