AIM13 Commentary - 2024 Q1
“Courage is doing things even when you’re scared.”
“Sometimes the hardest thing to do is to do nothing.”
With markets reaching all-time highs in recent weeks, many investors in the market and in private equity are frozen with fear. Having been whiplashed over the last four years since the pandemic by wild swings in public markets and, more dramatically, in private equity and venture capital, many senior investors at endowments, foundations, and family offices tell us that they are unsure where to invest. At times like this, when others are fearful, we have found great opportunities, investing in public markets through hedged strategies and in private markets with managers who are experienced and can take advantage of today’s unique opportunity set. The key in this environment is patience and discipline. For these reasons, we chose the two quotes above on the importance of both having the courage to act when others are fearful but also never forgetting that sometimes doing nothing may be the best strategy.
Why Hedged Funds Now?
“The will to not lose is more important than the will to win.”
We include with every letter our chart on the power of negative numbers to reinforce our primary guiding principle for investing in the public markets: preservation of capital during downturns is the key to superior investment returns over the long term. Looking back over the prior two years, as interest rates spiked and inflation surged, we have had some of the largest monthly pullbacks in our 25+ years of investing yet we believe hedge fund downside protection in the period has been strong. We think that downside shocks will continue, and only by remaining hedged will we reduce the long-term capital impairment that results from such shocks for long only and passive portfolios.
In addition, while we continue to maintain a cloudy view of the economy and equity markets in general and of the geopolitical environment, several current dynamics are providing significant tailwinds for hedged managers. The higher rate environment has not only made cash balances a meaningful source of returns, the interest earned on collateral for borrowed stock (known as the short rebate) has also helped managers with meaningful short portfolio allocations. More normalized rates have also weeded out less robust companies that relied on debt to stay afloat, which has increased stock price dispersion, rewarding active managers paid to distinguish between the good and the bad.
For our public equity portion of our portfolio, we try to identify risks, determine if they are acceptable, and, most importantly, maintain a hedged portfolio since we want to remain invested and not miss out on any upside. After a period of underperformance relative to the bull market and despite the continued unpopularity of the strategy, we believe hedged funds are the right place for the opportunities we see for this portion of our portfolio.
Why Private Equity Now?
“Be fearful when others are greedy and greedy when others are fearful.”
Over the past four years, private equity investors have lived through one of the largest swings in temperament that we have ever experienced in our lifetimes. At the industry’s peak three years ago, company founders were dictating terms and raising capital without any trouble. As one VC put it to us recently, it was like, “Here is my termsheet. I’ll expect funding by the end of the week.” Many less disciplined managers were happy to oblige and rapidly deployed capital. Now, with deal activity way down in 2022-2023 and overleveraged firms feeling the pain of higher rates, capital calls have far outpaced distributions:
Net Cash Flows from Private Equity Turned Negative in 2023
Source: UBS based on Pitchbook Date (2024)
This imbalance scares a lot of private equity investors. Many now find themselves over committed to the space, sitting on questionable marks, and with no fresh cash to deploy. Having remained disciplined in our deployment of capital to private strategies, we have as much dry powder to invest today as we did in 2020-2022. We believe this creates enormous opportunities. Following such a period of dislocation, we think the outlook for returns in private equity and venture capital are as good as we have seen in years. In fact we believe the opportunity set is similar to periods during sharp public equity downturns, which have historically provided some of the best vintages:
Some of PE’s Strongest Vintages Began During Downturns and Periods of Dislocation
Source: New World Advisors, based on data from Cambridge Associates U.S. Buyout Index.
As highlighted in UBS’s Private Markets 2Q24 review, several current trends are particularly favorable for private equity investors:
PE valuations have seemed to have found a bottom, with entry multiples at their lowest in several years.
M&A activity has also appeared to have troughed with deal count finally ticking up in the first quarter.
Access to fast-growing businesses through listed equities is harder than ever as more firms remain private equity-backed.
Banks continue to exit the financing market for small to mid-size firms, creating more opportunities for private equity and private credit strategies.
The Bottom Line: Proceed with Caution, but Still Proceed.
“The road of life is paved with flat squirrels who couldn’t make a decision.”
Howard Marks said recently that “the outlook is as unpredictable as ever.” Over-reacting, however, either on positive or negative news or trends, is not the way to generate superior returns over the long term. Nor is being frozen into inaction. In this environment, we wake up every day trying to tilt things in our favor, and we think we do that best by partnering with smart, experienced managers primarily using hedged strategies in public equities and low/middle market buyout strategies in private equity.
Our Observations for the Quarter
“Turning-points have less to do with sober-headed analysis than mob psychology”
As we discussed above, we think investors are right to be nervous about a wide range of things in the markets and throughout the world today, any one of which could spark a crisis and send everyone running for the exits. A few notable things we are particularly concerned about include:
Elevated Valuations. According to recent research from The Economist, cyclically adjusted price-earnings (CAPE) ratio, popularized by Yale’s Robert Schiller, is now higher than it was even in the late 1920’s. Not surprisingly, with Treasury yields at their highest levels in more than 15 years (according to MarketWatch) and the S&P 500 TR at or near record highs, the premium that investors gain for taking the risk of owning stocks has not been this low since the early 2000’s:
The Equity Risk Premium Has Not Been This Unfavorable Since 2001
Source: Bloomberg, as of March 31, 2024, as republished by Oaktree Insights, 1Q 2024.
An Ever More Concentrated Market. The weight of the top ten stocks in the S&P 500 hit its highest level in history at the end of the quarter:
Source: JP Morgan First Quarter Review (2024)
Research is mixed about what the increasing concentration of the equity markets means in terms of what may happen next. According to a note by Goldman Sachs in March, in prior periods such as 1973 and 2000 when, like today, unemployment was low and concentration was rising along with equity market returns, “[t]he peak of equity market concentration also marked the peak of a bull market, and the economy entered recession within the subsequent year,” its author Ben Snider wrote. What is more obvious is that, just like in any portfolio, higher concentration typically means higher risk, and this risk has played out recently. According to Goldman Sachs research, the so-called Magnificent Seven caused the most pain during the market’s 2022 equity drawdown, returning –39%, compared to –20% for the remaining companies in the S&P 500.
Corporate Debt Service Spiking. A lot has been written about the rise in national debt and the costs of servicing that debt for years to come. This is a serious concern, and we are in uncharted territory in terms of its impact. Less talked about is rising corporate debt service which more directly impacts firms’ profit margins.
Corporate Interest Expenses Expected to Rise Sharply
Source: Goldman Sachs Global Investment Research
If interest rates do not come down, as lower rate debt needs to be refinanced, companies will be forced to spend a greater share of their revenue to cover higher interest expenses. According to a Goldman Sachs research note last year, refinancing maturing debt will increase interest expenses by 2% in 2024 and 5.5% in 2025. The pace of refinancings as corporate debt matures will sharply increase this year and next. Goldman estimated that while only $525B of debt matured in 2023, that number will be more like $790B in 2024, and a little over $1T in 2025. The interest expense increases associated with this maturity wall will have enormous implications on what firms can spend on things like capex and hiring, which likewise will place greater recessionary pressures on the economy.
The Impact of Persistent Inflation on the Working Class. Many of us lose sight of the impact of inflation on workers who spend most of their income on necessities such as food and rent. Charlie Bilello recently highlighted a Wall Street Journal analysis showing that a commonly purchased basket of supermarket goods has increased in price by 36.5% over the past four years (or +8.1% per year). This is much higher than the US Government CPI figures which show food price inflation of 25.2% over the last 4 years or +5.8% per year. In fact, as the chart below from the New York Post illustrates, Americans have not spent this much of their incomes on food since the Gulf War:
Source: New York Post (Feb 21, 2024)
This dynamic is one part of why we see so much discontentment and distrust among many working class Americans. Heading into an already politically charged presidential election season, we are concerned we may see some of the same clashes following the prior election again this fall and winter.
The Upcoming Election and the Rise of A/I-Generated Disinformation
According to a survey in the World Economic Forum’s 2024 Global Risks Report, when asked about risks most likely to present a material crisis on a global scale in 2024, respondents said that AI-generated misinformation and disinformation is the second greatest threat, behind just climate change and ahead of political polarization, cost of living crisis, and cyberattacks. This view was reinforced by testimony on May 15th by Avril Haines, the Director of National Intelligence, who described to the Senate Intelligence Committee Russia’s actions to undermine the upcoming election. What this all means for investors remains to be seen but we are concerned that new A/I-based tools hugely magnify the risk of voters being misled by what they consume on the Internet. False information leads to the erosion of trust, further driving people to only consume information that they are predisposed to think is true and disregarding information that they think is false – regardless of what actually is true or false. The implications of this for our national stability are enormous.
We welcome any questions or thoughts you may have.
Sincerely,
Alternative Investment Management, LLC (AIM13)