I am delighted to write another post for Movemeon as part of my series on Private Equity. This post will I hope trigger significant interest as I am dealing with the job hunting process itself. Any comment is obviously welcome.
Central banks across the world have been trying to reignite inflation by injecting a massive amount of liquidity and buying financial instruments, most recently corporate bonds. In theory, a higher supply of money should devalue the currency, thus boosting both exports and domestic demand. In particular, demand translates into more investment, which is a necessary cornerstone for long-term growth. Needless to say, this classic monetary tool has been more than widely used over the last few months. But the target remains out of reach in many countries. Despite more than $1tn of debt now yielding negative interest rates, inflation barely climbed to 0.6% in the UK. The US Fed is considering raising interest rates again although inflation in the US is 2.2% and thus barely exceeds the official 2% target.
I have already highlighted in this blog the importance of confidence in driving the decision of individuals. When people are confident about the future (i.e. they can predict with relative certainty the future state of the economy and the implication for their personal wealth) they do not hesitate to invest part of their income in ‘non-vital goods and services’ such as domestic appliances, automotive etc. The same logic applies to companies – this is what we call investment. Today’s environment largely lacks visibility. Geopolitical concerns (elections in the US, France and Germany, Brexit in the UK, tensions in the Middle East) make economic decisions even harder to predict. As a consequence, despite the affordability of debt, households and companies prefer to save today in case the situation gets tougher tomorrow. The resulting drop in demand has been widely pointed out as a cause for low inflation or potentially deflation in some areas (e.g. food in the UK).
Not only are hyper-low interest rates inefficient, they are counterproductive, and central banks should raise interest rates as early as feasible. Let me explain. The excessive amount of non-invested liquidity has led individuals and companies to invest in financial assets such as bonds or funds. Venture capital funds have been particularly in demand given their risk-reward profile; they tend to be more risky than ‘plain LBO’ funds and according to theory should yield better expected returns. Unsurprisingly E&Y in its latest global venture capital trends report states that venture capital deal activity increased by 54% in 2015 to reach $148bn.
Flooded with liquidity venture capitalists are begging for start-up ideas to invest their money – given that the worst scenario for an asset manager is to show his investors that their commitments are sleeping at the bank. The number of start-ups has been logically soaring in all developed economies as a result, sometimes giving birth to incubators, the most famous certainly being Rocket Internet, and a few have been raising tens or even hundreds of millions of dollars to boost their development.
In the 2.0 economy, where marginal costs are almost non-existent and barriers to entry are low, ‘customer acquisition’ and ‘network effect’ are the new mantras. Rather than investing in expensive marketing campaigns, start-ups have decided to invest in prices, most often selling their services at a loss to ensure maximal penetration. Uber is a good example. Rides in London are on average 30% cheaper than a black cab. The company is present in more than 500 cities and has been valued at $68bn in its latest fundraising round completed last year. And yet, Uber reported $1.2bn in losses in H1 2016 – this raises a broader debate about the criteria for start-up valuation, which we will address in a later post.
Private investors have shown patience so far, hoping that the ‘hockey stick’ will materialise. And if it does not, investors often believe that it is simply due to a lack of scale and that further investment is required to ensure the user base is large enough to prove profitable. The stock market, conversely, has been indifferent to this thesis and very few start-ups have succeeded to make a strong enough profit to reach the IPO stage – a feature that differs from the 2000 ‘dot-com’ bubble.
My point is that for months now many aspects of our daily life have been ‘subsidised’ by increasingly risk-seeking venture capitalists and that behaviour has largely been driven by the abnormally high amounts of liquidity made available by Central Banks. Paradoxically, these start-ups have most often been bringing down prices and ultimately favouring deflation, pushing Central Banks further away from their initial objective. I am not saying that price cuts are always bad. But in this case price cuts have only come at the cost of corporate losses – simply put: value destruction.
The argument about the ‘hunt for worldwide scale’ is dubious. Although this hunt is legitimate in a limited number of cases (social networks represent the most typical examples), entering new markets brings limited benefits to most start-ups. When Uber decides to enter Santiago, it cannot rely on network effect: the taxi drivers operating in Santiago are different from the ones in Singapore and the customer base is also very distinct. Given the very lean cost base, the only synergy it can expect is the brand power – which may not justify hundreds of millions of dollars of losses. And, even if you do so, you cannot prevent an aggressive competitor to emerge with even lower prices – only the depth of the investors’ pockets will make the difference.
My recommandation to Central Bank governors is thus simple: raise interest rates and clean up the mess. We will not find growth by artificially subsidising value-destructing activities. The fear of the next crisis and the willingness to avoid recession at all costs are leaving everyone in doubt. Take the hit, start from a fresh and economically sane breeding-ground and build again from there.
I am delighted to have the latest post from my PE Series published on MoveMeOn’s website. I have decided to tackle the often widespread idea that private equity only offers upsides compared with life in consulting. Although private equity can, in many respects, represent a better ‘package’, I believe there are a few ‘less positive’ aspects worth considering before making the jump.
The article can be found here. Thanks again to Rich and Bebe for including me in that wonderful venture.
Last month I had the opportunity to write about the difficult times the hedge funds industry was going through, facing quarterly outflows never seen since the last financial crisis – a downward trend that remained vivid in Q1 2016 – and which does not spare top ‘brands’ such as Pimco. Although the outflow only represents 0.5% of the total hedge fund AuM base, experts have been calling for a change in the way hedge funds operate. In summary, all recommendations do not add anything new to classic strategy textbooks which have taught us for decades that a company could build and maintain a competitive edge in three ways: through (i) lower prices and/or through products offering (ii) higher quality and/or (iii) better fit to customer needs (for instance, think about pack sizes in retail). Hedge funds are no different in that respect and I believe each of those three levers is worth investigating.
The infamous ‘2+20′ mantra which used to drive hedge funds’ remuneration policy (i.e. 2% of annual management fees plus 20% of the share of profits above a certain IRR) cannot be considered as a standard anymore. It should not have become in the first place anyway. The ‘2+20’ was indeed originally designed by private equity fund managers as a reward for the effort they ut into identifying promising investments, negotiating the best deal terms and then developing the companies. The hedge fund manager only adopts a ‘passive’ approach to investing by focusing only on the first point and, to a lesser extent, on the second (although the impact of market timing is limited). As a consequence, one should expect the work of the hedge fund manager to add less value compared with his PE counterpart. In any case, pressure on fees can be felt across asset classes and the ‘2+20’ has left room to the ‘1.5+15’ or even to the ‘1+0’.
Ucits, a regulated and often cheaper alternative investment offering a similar performance to hedge funds, have conversely enjoyed significant inflows since the start of the year – €8bn according to Les Echos. Ucits will come on top of the already mainstream ‘passive’ ETFs to put additional price pressure on ‘traditional’ hedge funds.
Such global pressure on fees has obvious consequences on the way asset managers in general operate: low-performing funds have either tightened their expense policies (think about Goldman Sachs Asset Management for instance) or simply closed.
Enhancing existing products
Hedge funds have often been criticised for all following the same active strategies which can in some cases not even be qualified as ‘active’ – see my earlier post on this point. The ‘herd mentality’ comes with two major drawbacks: first, no hedge fund is truly uncorrelated from the market as a result and, second, each position change triggers massive money flows and thus price fluctuations which can destroy returns even if the investment was originally a good idea. To alleviate that risk, hedge funds will likely reduce their size and focus on ‘niche’ strategies away from the mainstream market. To do so, hedge fund managers need to be allowed to suffer short-term losses if that drives long-term profits, in particular if those profits offer low correlation with the way the rest of the market behaves.
And yet, markets are volatile, relatively undecided and we are currently living in a world of ‘lows’ (low inflation, low growth, low interest rates). Are open-ended hedge funds the highest performing asset class in that context? Volatility leads investors to make frequent changes to their money allocation strategy if they are left free to do so. Hedge fund managers are therefore strongly incentivised to maintain a high level of liquidity in their portfolio and adopt a short-term approach in order to avoid heavy redemption and the detrimental asset ‘fire sale’ it generally triggers – a particularly acute problem for real estate funds, as Standard Life showed us yesterday. This strategy will negatively impact returns. As a consequence, some hedge fund managers have started introducing ‘lock-in’ periods (as PE funds already do) to enable them to follow true long-term strategies even if they prove to be losing in the short-term.
Adding or creating more adapted strategies
Private equity as an asset class which not only solves the issue of ‘lock-in’ and offers additional value creation levers for fund managers but also relatively outperforms other alternative asset classes – see a French example below.
As a consequence, despite the already high number of competitors in the industry, some hedge funds have decided to diversify by adding, explicitly or implicitly, a PE arm to their activities. Elliott’s joint acquisition of Dell’s software division last month – funded from their $28bn main fund – is only the tip of the iceberg.
Quant funds benefit from tailwind as well. Despite average performance, investors appreciate the ‘systematic’ (since algorithmic by definition) approach to investing in turbulent times. The Financial Times reports that commodity-trading advisers (CTAs) received $38bn in capital inflow in 2015.
Finally, hedge funds’ ‘product innovation departments’ have been running full speed over the last few months in an attempt to maintain fees as high as possible – a trick used in retail as well. Factor investing, smart beta, low volatility funds have all attracted money recently but these strategies remain unproven (‘factor investing’ is still nascent given its complexity), non-scalable (what happens to a ‘low volatility’ fund when strong flows generate volatility?) or, worse, dangerous (Rob Arnott, pioneer of ‘smart beta’, recently criticised the excesses of this strategy).
It is unclear which hedge funds will succeed and which ones will be wiped out as a result of the industry transformation movement we are witnessing. Size of the asset base only offers a mediocre indication as in the future the most successful funds may be those able to navigate ‘under the radar’. In any case, investors are becoming increasingly educated and scrupulous on costs – ‘status quo’ is thus not an option.
The third post of my PE Series for MoveMeOn was published earlier this week. I have been listing questions that you should have answers to prior to accepting an offer in a private equity fund. Indeed, each fund has its own operating model, structure and culture and each candidate needs to make sure that all the aspects of the offer suit him before signing.
The PE series is a nice way to introduce readers to the career event dedicated to PE I will be holding jointly with MoveMeOn on the 16th. More information to follow…