The Shaky Foundations of Asset Allocation Practices, Continued
Our 1st Quarter letter addressed the question of whether some basic presumptions of asset allocation work in the real world the way every one presumes them to… such as whether emerging markets equities actually outperform developed markets, whether the historical rate of return from the stock market can be repeated or is, indeed, even valid, and so forth. Understanding these questions can hardly be more critical, since we all invest based on these foundational assumptions. One element such models share is that in the freedom of the marketplace, any rigid, definitional approach will come to be invalid, later if not sooner, since investors do react to new information and, thereby, alter supply and pricing. If a particular sector is discovered to be superior or to outperform, will not capital flow into it and inflate the price? And at what degree of price inflation does the sector become a source of average or negative, rather than superior, return?
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Another shared element in the accepted wisdom of asset allocation practice is the selection of a factor that is merely semantically descriptive but not intrinsically predictive. An example would be to label an index comprised of companies domiciled or incorporated in a given emerging nation or set of nations as an emerging market index, even if it happens to be significantly constituted by multi-national businesses with stock market values every bit as large as the largest developed market companies. Or, there is the reliance upon the historical returns and behavior of an index without examining how it was created: what if the greatest and most influential returns from an index occurred during a period or with a set of securities that was unique to that period and circumstance, and is no longer repeatable? An example would be an index dominated in its early years by one or a handful of dramatically undervalued securities, yet which in the current era is relatively diverse and reasonably valued.
The 1st quarter commentary addressed the question, labelled Proposition 1a, of whether emerging markets stocks actually outperform domestic stocks. This commentary will address Proposition 2b: I invest some of my portfolio in private equity for: a) return enhancement; b) lower volatility; and c) risk diversification. Do you really receive all of those presumed benefits?
a) Private Equity: The Official Record
Big institutions plan to make yet more investments in private equity. We know that from a poll by Preqin1, which is probably the leading compiler of data on private equity and other alternative asset classes. According to this poll of large institutions, 45% of 430 respondents—a quite large sample of institutions, lending it validity—stated that private equity is the best alternative investment opportunity. It is noteworthy that alternative assets under management now have reached the level of $6 trillion and, according to the poll, 68% of respondents stated that they will commit more money to private equity in 2014.
The following table, the Preqin Private Equity Committed Capital Index, is very interesting. It shows the unit values of all private equity funds in its universe on a committed capital basis—meaning the money that is actually invested, not uninvested cash subject to capital calls—therefore, this is an index that effectively measures what happens to fully-invested portfolios. As can be seen in the quarterly return column, there is not one double-digit number—either positive or negative—during the 14-year period tracked, which begins in December 1999 and ends in June 2013.
Bearing in mind that these return figures are not based on public share prices, but on the estimates made by the private equity firms themselves of the values of their private equity investments, let’s compare this with the actual, rather than theoretical, price behavior of two publicly-traded such companies, The Blackstone Group and Onex Corp., which are major participants in this field and probably two with the longest pedigree. Since they are publicly-traded, their shares represent two sources of return from investors’ point of view: both invest their capital alongside private equity investors, and they also collect the fees for managing their clients’ capital.
During 2008, the total return, inclusive of dividends, if any, was negative 67.4% for Blackstone and negative 48.9% for Onex. The S&P 500 Index (“S&P 500”) return was negative 37% that year and the high-yield index, HYG, had a negative return of 23.9%. Interestingly, the high-yield index contained many of the bonds issued by many of the private equity deals—bonds, after all, that are ranked senior to equities.
With all that in mind, consider that the total return of the Private Equity Index of Committed Capital in 2008 was negative 14.2%. In other words, private equity, according to the record, outperformed not only the private equity firms that have the very significant benefit of collecting the fees generated from those deals and have their money invested in the exact same deals, but it also outperformed an index that included the bonds that finance the private equity deals themselves. Irrespective of how junior those bonds might have been, they still would be senior to equities. This outperformance is said to have occurred during the worst financial crisis in about a century, when the credit markets essentially froze. Is that not astonishing? How would one explain it? In this light, the Preqin index is an extraordinary document.
b) Private Equity, in Asset Allocation Argot: Duration Risk and Diversification Risk
Rarely does a day go by that the media does not focus upon possible—or coming, if one prefers— increases in interest rates, changes in the interest rate environment, and the damage that it can do to a bond portfolio. If one reviews some broadly representative bond indexes, like the iShares Core Total U.S. Bond Market ETF (AGG), which emulates all the investment grade bonds in the United States, one will find that the average maturity is not much longer than six years. Or, taking the iShares iBoxx $ High Yield Corporate Bond ETF, the average maturity is just over four years. In other words, even though there are buyers of 30-year bonds, looking at the bond market as a whole, it is clear that very few are interested in taking duration risk. Everyone is aware of the interest rate risk, and they are preparing for it. Bond buyers, especially those taking credit risk, certainly do not want to add duration risk.
However, there is one group taking the risk, but it just does not realize it. In that group are those institutions—and they are only institutions—that are placing large amounts of money in private equity. They think they are lowering risk. They are removing money from publicly traded equity, and even bonds in some cases, and placing it in private equity.
Of course, private equity is borrowing the money because it is only private equity in name. A more functionally accurate term would be leveraged equity. The idea behind buy-out private equity investing is to find a suitable public company, pay a control premium for it, and then bring it private with an extraordinary amount of debt. If the maturities on those borrowings are short (and, unlike the historical norm, there is much less availability of long-term high-yield lending to match the extended workout periods ordinarily required for private equity) and if interest rates rise, then the refinancing risk is entirely on the private equity investor. The bond buyer, assuming the company remains solvent, is going to get a higher coupon; the private equity investor is going to pay the higher coupon.
The maximum risk one can take in bonds is the risk of being the borrower (as opposed to a lender). The lender, such as a bond holder, can legally enforce payment by a troubled borrower, can force bankruptcy if necessary, and has dominating influence in bankruptcy proceedings, where the weakest interested party is typically the common equity owner. Paradoxically, private equity investors are making themselves, effectively, large-scale borrowers in that the institutions that place or pledge equity with the private equity firms as limited partners, by putting themselves in the position of providing a small amount of equity collateral to back the substantial borrowing of the deals, are essentially issuers of a) low-quality debt, or b) debt that can become low or lower-quality quite rapidly. In both cases, this debt is subject to refinancing risk during a period that is an historic bottom in interest rates. It is astonishing that institutions and asset allocators that are very mindful of duration risk are actually taking the greatest duration risk they have ever taken (although, to be precise, it is not duration risk in the conventional sense, so much as it is really refinancing risk). It is a different kind of risk than in bonds. There may be select institutions that understand the underlying refinancing risk; however, we surmise many are unaware.
Looking at the world of private equity statistically, one can see an alluring Sharpe ratio (which measures the amount of price volatility relative to the return experienced). Historically, there has not been a lot of volatility in private equity, and it has provided an acceptable rate of return for that limited volatility. Of course, during the entire time span of those historical rates of return, interest rates have been declining, not going up. There is no data on what happens when the maturities are short and the refinancing risk is high. That should prove a very interesting data point when it arrives.