Take the Free Lunch
Ask a CIO: Week 3
Another week, another new high for the S&P 500.
The ongoing public market run-up has prompted a blunt reader question around the value of diversification. A lot of institutional investors, myself admittedly included, have a knee-jerk reaction when it comes to defending portfolio diversification. Harry Markowitz called diversification the “only free lunch” in finance, but honestly, at this point it’s also dogma (and not without reason).
And yet for a growing number of investors, public equities in general and the S&P 500 in particular, appear unbeatable. So why bother with anything else?
Why Bother
I’m young, so why shouldn’t I be 100% public equities?
I totally get where you’re coming from. There’s something incredibly appealing about having a simple answer (100% equities, all growth all the time) to a complex problem (future investment expectations).
And if public equity markets continue to behave as they have for the past 15 years, then yes, it’s even easier to make the case for being 100% public equities. And that is one possibility out of many possible future market scenarios.
Now imagine a different scenario – a deep market correction and recession.1 Let’s use the Global Financial Crisis as a reference point. From peak to trough (October 9, 2007 to March 9, 2009), the S&P 500 Index declined 54.9%. In August 2012, over four years later, the S&P finally recovered back to where it stood before the decline. That’s a long time to wait for your 100% equities portfolio to recover. And that’s assuming you have the fortitude to hold on to your equities through the drawdown and subsequent recovery.
Do I really think we’re headed for another GFC level recession? Not really. But there are a bunch of scenarios that exist between indefinite sunny skies and a deep near-term recession. Diversification gives you a greater ability to navigate through a wider variety of scenarios. And over the long-term, avoiding bad decisions (i.e., buying high and selling low) is just as important as making good decisions.
That’s the intellectual argument.2
I’ll also make the practical argument. If you are truly a long-term investor, one that would hold tight to daily liquidity equities even when they’re dropping like stones, there are private asset classes that have historically generated similar or higher returns versus public equities. With all the usual caveats that past performance doesn’t guarantee future performance (and risk is harder to quantify in private assets), private equity has historically offered returns that are better than public equities, while private credit and real assets have offered competitive returns with lower volatility. And with the caveat that assumptions are just that3 – capital market assumptions published by BlackRock, JPMorgan, PIMCO, and others all project higher returns for these alternative asset classes relative to public equities on a forward-looking basis.
So if I have the full suite of investment options at my disposal (which Ivy Invest does), then I’m trying to stack the investment odds in my favor. A diversified portfolio that over the long-term offers a higher expected return while also offering downside protection in the event of market declines seems like a better choice than 100% public equities.
$800 billion market
Maybe private credit isn’t new, but what about direct lending? Don’t you think there’s a lot of risk in that market?
Direct lending is also not actually new, but the size of the market is new. And unpacking the risk requires unpacking the size a bit.
The estimates vary, but from what I’ve seen, most put the U.S. direct lending market at between $600 billion to $800 billion. Regardless of which estimate you use, direct lending is a huge market, and it has ballooned in recent years. A lot has already been written about the reason for the growth in direct lending, so I won’t rehash it here, but it boils down to banks post GFC pulling back from lending to the middle and smaller ends of the private equity market.
Stepping back for a second, direct lending refers to senior secured debt that is directly negotiated between the lender and a particular type of borrower – typically a private equity firm looking to finance a leveraged buyout transaction. I think of direct lending in 3 categories: large buyout, middle market buyout, and non-sponsor. The first two categories I listed here refer to the size of private equity firms and transactions, and the last category refers to one-off leveraged buyout transactions completed by equity investors that aren’t part of any firm.
In general, and there are always exceptions, but in general – larger buyout firms use both the broadly syndicated loan market (BSL) and direct lenders to finance their company purchases.4 The large buyout firms toggle between the BSL market and direct lenders largely based on terms and availability of capital. The competition means that these larger loans are somewhat commoditized in terms of loan docs and terms, so that covenants and documentation are going to be on the looser side. Direct lenders catering to the large part of the market are lending to bigger companies backed by bigger sponsors, so theoretically it’s an OK tradeoff to make. Spreads will be tighter and total returns lower.
The middle market lenders are generally working with companies that aren’t strong enough to tap into the BSL market, so they’re competing mostly with other direct lenders. There’s still competition on terms, but generalizing again, the covenants and documentation will be tighter. Spreads are wider and total returns are higher to reflect the smaller nature of these companies and the fewer options for capital. This is probably the best mix of risk/return in direct lending, as there are still private equity sponsors supporting the companies.
The last group is the non-sponsor direct lenders. This is a smaller group of lenders that focuses on one-off leveraged buyout transactions by buyers without a fund. The direct lending funds dedicated to non-sponsor buyout transactions generally make me a little nervous.5 These non-sponsor loans unsurprisingly offer the highest spreads and highest total returns. But when things go south, they can go really south.
I took a detour, but back to your question, is there a lot of risk in the market? Without knowing exactly what risk you’re asking about, I’ll answer the question in two ways.
First, is there too much risk, as in are there too many loosely underwritten loans that will default? Almost certainly yes? I mean, default rates are definitely going to go up, and they already have been ticking up. The bigger question is, what will recoveries look like in default scenarios? That’s going to vary a lot by investment manager. Some firms have standing workout teams and the ability to step in as equity owners of business – in these situations, the workout process will extend the investment timeline, but could result in higher overall returns. Other firms…do not.
Second, is there too much risk in the system? I’ve been hearing this argument a bit lately – that private credit and the leverage associated with it is the hidden risk in the system. Yes, direct lending funds are typically levered, with the debt to equity ratio typically being somewhere from 1:1 to 2:1. Is that a lot of leverage? It is leverage on leverage, as in the funds make loans, and use leverage themselves to make more loans. But the vast majority of loans are senior secured loans made to companies backed by private equity firms – if the direct lender is taking a loss on a loan, then the private equity firm is taking a zero. If direct loan portfolios are impaired, the losses to fund investors will be compounded by the leverage. But it doesn’t strike me as a systemic, subprime debt-type hidden risk scenario.
Making new friends
I’m starting out in my career and part of a small investment team. I keep hearing about the value of networks, but it’s hard finding other investors to connect with – how do I start building a network?
It is hard to start building a network! But it really is invaluable for idea sharing, reference checks, general sanity checks, and ultimately, your own career progression.
There are a lot of different things you could do to maximize the number of people that you meet – social events for investors in your area, conferences, professional organizations, etc. In my experience, these larger spaces are more effective for catching up with people you already know and deepening existing relationships.
If you’re starting out, I would offer the following advice:
Be kind to marketers – great marketers know the LP community well and are the ultimate connectors. There are so many wonderful BD and IR folks in this business who have been and continue to be great friends and mentors to me. If you ask nicely, they’ll often gladly introduce you to other LPs. And then it’s on you to follow up and build from there. Some of my closest LP friends started as introductions from a mutual marketing friend that said hey, you’re like minded investors, and I think you’d get along.
Actively seek out senior professionals as mentors and be diligent in maintaining the relationship. Mentorship is a two-way street, and it has to be a fit for both people involved. If you find a great mentor that you click with, put in the work to stay in touch. Check in regularly. It will pay enormous dividends over time and will feel rewarding to both of you.
Don’t underestimate your peer network. As you grow in your career, your formerly junior peers will also be growing through the ranks. You’ll find yourself in mid-level and later senior level roles at roughly the same times in your professional lives. And if you’ve built trust and friendship, you’ll be the best advocates for each other for everything from investment in access constrained funds to coveted job openings.
Building networks and relationships is a long game – it takes time, but you’ll get there. Be kind. Give first. And whenever possible, as you get to know someone, ask them (and really mean it) – how can I be helpful to you?6
Until next week,
Wendy
Institutional investors are consummate scenario testers. We just love running our portfolios and various investments through hypothetical scenarios, and our favorite scenario to stress a portfolio with is probably the 2008-2009 global financial crisis.
For the record, I fully believe in the intellectual argument, and think it is justification enough.
The technical term here would be garbage in garbage out. Kidding! Sort of.
The lender disputes (“lender on lender violence”) that we’ve seen pop up in recent years are mostly occurring in BSLs due to the looser documentation that allowed very borrower friendly terms to prevail in the low rate environment. The larger direct lending firms that compete against BSLs to make loans to borrowers might have some similar issues in their loan documents. As a slightly funny aside, there is a particular law firm that has been most responsible for drafting the disputed loan documents, and it has also been the firm that is most frequently hired to exploit the loopholes in those same documents.
These non-sponsor focused direct lending funds are distinct from special situations investors that might also engage in non-sponsor transactions.
Shout out to a great friend, JL, who is always sincere in asking this question, and whose excellent sensibility has since rubbed off on me.