Tag: private equity

Treasure Chest

John Maynard Keynes is very well known for his contributions to economics and policy making, but less so for his investing prowess. In the 1920’s Keynes worked as a portfolio manager for two insurance companies and from 1921 to 1946 ran the endowment (the ‘Chest’) for King’s College, Cambridge. Keynes’ investing performance is the subject of some fascinating research by David Chambers and Elroy Dimson.

Early in his career Keynes was what we might call a macro investor, focusing on commodities and foreign exchange. Later, he became more focused on stocks, and from the 1930’s Keynes beat the (stock) market by over 5% per year despite several close shaves with personal bankruptcy.

Viewed from the point of view of today’s stock market, what was unusual about Keynes’ style was that in the 1920’s and 1930’s equities were very much the preserve of retail investors, and not so much institutional managers. 

To that end, Chambers and Dimson remark that Keynes’ early allocation to equities was ‘as radical as the much later move to illiquid assets in the late 20th century by Yale’. Unsurprisingly, Keynes’ investing style, which was driven by strong macro-economic views and focused on a few, large and often concentrated positions (if he was investing today he would likely be heavily invested in mega-cap technology stocks) has influenced modern endowment managers, most notably David Swensen of Yale.

Swensen pioneered the move by large US university endowments towards private assets (notably private equity, but also infrastructure and venture), a strategy that has proven remarkably profitable. The top endowments, generally Ivy League schools and other top ranking universities like MIT, have consistently made double digit returns, spurred by annual §private equity returns in the very high teens.

However, the endowment model is coming under scrutiny, partly because some universities have overinvested in private assets at a time when capital distributions have slowed (my former employer Princeton University has effectively invested up to 40% of its portfolio in private equity and venture), and partly because universities themselves have adjusted their expenditure upwards whilst they have enjoyed generous disbursements from performing endowments.

Endowments in the US originally paid 4% of their value to universities annually but in some cases this has risen to 12% (in turn pressuring endowment managers to produce returns). Broadly, disbursements from endowments amount to close to 30% of university budgets with much of it spent on student financial aid. Given that cash distributions from private equity funds have slowed, the knock on to university spending is being felt.

Anyone who has visited a top-flight US university and witnessed the extent to which laboratories, sports facilities and student bursaries are well funded will appreciate the size of university budgets and the role that endowments play. In Europe, only ETH Zurich can match this level of financial backing.

The debate on endowment investing has been enlivened by the publication in February of the 50th NACUBO Endowment Study. In general, the nearly 700 endowments surveyed in the report hold less fixed income than I would imagine for a typical ‘balanced’ investor, more ‘foreign’ equities than US (this might explain some underperformance), and nearly 50% alternative assets (including a large slug of hedge funds).

Interestingly from the point of Keynes’ active management stance, nearly 50% of US endowments ‘outsourced’ their investment office function. Reflecting this, allocations to private equity, returns and return distribution tend to be better in the larger endowments that have well-equipped investment teams.

In turn this reflects the reality that private equity and venture are two of the asset classes (unlike equity and bond funds) where returns are highly dispersed (i.e. there is a large difference between the best and worst performing funds). As such, finding the best performing funds and gaining access to them has a cost in terms of investment research resources. To this end, I wonder if many universities have really been following the ‘endowment’ model as pioneered by Keynes and Swensen.

Indeed, one of the secrets of the performance of the Yale and Harvard models is that they have very good networks of alumni in the private investment industry, who willingly proffered the best advice and access to their alma mater.

Supporting this theory, Keynes had a similar network of former students around the world (notably in Africa – think mining stocks and commodities) who offered him advice, information and investment opportunities and he also had access to relatively sophisticated telegram technology, so that in some cases he had access to market moving information before others. Further, Keynes was unlike many investors today in that his colleagues at King’s had great faith in him and gave him enormous freedom to pursue his own investment style.

This ‘freedom’ has been all but quashed by benchmarking and technology in public markets (i.e. equity and bond funds) but still exits in private markets – the trick is to find the Keynes like managers.

Have a great week ahead,

Mike

Wir sind alles Metallgesellschaft

An unhappy meeting of finance and industry

The behaviour of the price of oil in the last week was, to understate the matter, jerratic. A sharply negative oil price (the first time since 1870 at least) in the May contract served to illustrate how topsy-turvy the economic world has become (I hope some airlines hedged in negative oil!). Together with the relatively recent advent of negative interest rates, negative oil prices will convince many that something is not right in the engine room of the global economy.

I mentioned in last week’s missive that assets like oil that did not fall under the spell of central bank asset purchases gave a truer indication of the economic outlook than those assets that did.  

In this context, the signal sent by the price of oil, even today, should be a cause for concern. Of course, other factors conspired to push oil into negative territory – notably a shortage of storage, the convince of some hedge funds and traders as well as the side effects of financial engineering (exchange traded fund (ETF) structuring).

This upside-down oil shock is not over and the effect of low oil prices will continue to ripple through emerging and high yield debt markets, emerging market currencies and the dollar, as well as banks and the Texan economy.

In the greater scheme of things, it also brought to mind the case of Metallgesellschaft, a giant German industrial conglomerate which in 1993 ran up a USD 1.5bn (a lot of money then) loss on an oil hedging contract. Metallgesellschaft fell foul of the same effect we witnessed last week, contango, where the price of near dated contracts (i.e. May) dropped well below the level of later dated contracts (e.g. July).

The Metallgesellschaft case left a mark on the financial economic history of the early 1990’s and is widely taught in business schools as a case study in the dangers of mixing business and financial engineering.

The collapse of Metallgesellschaft came at an early point in the deployment of derivatives in markets and should have served as a salutary lesson to corporates, regulators and banks. That was not the case.

For instance, the lesson that Deutsche Bank, which had arranged the hedging trades for Metallgesellschaft, apparently drew from the blowout, was to aggressively expand its investment banking operation. Today, the share price of Deutsche bank is down 95% on the level it reached before the global financial crisis (without being too unkind to Deutsche Bank, David Enrich’s ‘Dark Towers’ is worth a look).

What the jumpy oil price and Metallgesellschaft have in common is an instruction on how the real economy and finance have become increasingly intertwined.  

From an economic and investment point of view, there is plenty to consider in this regard. I am tempted to say that there is one sector that does not rely on finance – technology – but the corornavirus crisis has turned tech from an industrial gargantuan into a stock market monster (Microsoft, Apple, Amazon, Alphabet and Facebook account for 22% of the market capitalisation of the S&P 500 index). Next week’s tech earnings results may bring a reality check for stocks, and see volatility pick up.

The two other sectors to consider are banks and private equity. In the light of the Metallgesellschaft discussion what is remarkable so far in the coronavirus economic crisis, is that no bank has keeled over (I may speak too soon).

Indeed, the balance sheet restrictions that have been put in place, and general focus on risk management, appear to have paid off. In many countries, banks are now part of the rescue mechanism, and there is an opportunity for many of them to repair their reputations. In Europe the price of heavy regulation has, made banks very cheap from a valuation point of view so that there may be some upside if a round of consolidation takes hold into 2021.

Unlike banks, private equity has for some reason not come under the intense scrutiny of regulators, even as private equity (and private debt) have replaced the role of banks in parts of the global economy (i.e. shadow banks).

A crunch is coming however. In the USA, private equity companies are heavily invested in medium sized enterprises, and in any cases have taken on large amounts of debt to do so. As the economic toll of the coronavirus deepens, the financial pressure on private equity will translate into economic pressure on companies (leading to cost cuts and layoffs), and social pressure on their workforces. Sadly, this may have a deeper human, economic and political effect than the drama of negative oil prices and deserves to be watched closely by policy makers as the summer approaches.

Have a great week ahead,

Mike