Invest Like the Best with Patrick O'Shaughnessy
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: You should not do those terms, because it's all good when you're in a procyclical environment. But if you have capped upside and you're earning a 10% return and all the collateral that your 10% is based on can literally be taken out of your collateral package overnight. Or for that 10% return, you can be levered up because let's say there's an AI disruption and some software company needs to reposition their business and they can basically lever you up. So you go from 50% loan to value to 120% loan to value. Those are just things that you shouldn't do for a 10% return. [00:00:00] S0: The first time we did this, we talked a lot about return per unit of risk. It basically sounds like the thing happening in the factory model is that that has fallen out of whack. The objective function becomes more deployment of capital because that ties to size of my business, multiple on the business, how much money I'm making as a shareholder or whatever. And it's fundamentally divorced from the investing equation, which is return units per unit of risk or something like that. So map this on to the news cycle today. What is happening? Where are there asset-liability mismatches? What are the nature of them? What's the implications?
· Alan Waxman
[00:00:00] S1: Again, go back post-COVID, that's when the wealth space took off. So the democratization of alternatives or private capital, which just to be clear, not against that. Some of the factory models that are out there have raised capital from the wealth channel in irresponsible ways. So first of all, in general, you're taking an illiquid asset and you're giving investors an ability to get their money back quarterly. They say semi-liquid. There's no semi-liquid, okay, there's no such thing as semi-liquid. Anyone that's an investor that's been through a bunch of cycles – there's liquid, and then there's illiquid. Because again, going back to the history of the wealth channel or individuals or retail, the one thing we know, it's very procyclical. We're in a procyclical environment. It's easy to raise money. And when you're not, and when there's problems or dislocation like there is today, they want their money back. So you basically had mismatching of illiquid assets and liabilities. So that's one part of it. The second thing is that they would raise these very narrow – what I mean by narrow is it's just direct lending. So it's not like you can invest in direct lending and real estate and infrastructure or in asset-based finance. No, no, it's just very narrow. Just direct lending or just asset-based finance or just this strategy. That's a narrow strategy. And maybe that's okay if you raise the right amount of capital. But if you raise an unlimited amount of capital where your investing is dictated, not on good investments in the market, but basically dictated by how much money you can raise. There's never a governor on how much money to raise. And the thing about these wealth vehicles, when they raise it, they have to invest it right away. We call it inflow investing. They have to invest it right away. So they raise as much money as they can, and if they don't invest it right away, it dilutes the return of that vehicle.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: To ground this in actual reality as much as possible. We've talked about all these guardrails, all these incentives, the three problems. All this stuff where the system structure begins to determine fate. What is fate? What is actually happening today? [00:00:00] S1: What's happening today is there are these vehicles called perpetual private BDCs. These have been raised in the wealth channel. So individuals, wealthy, mass affluent, they've been raised. And again, in some cases, not all cases, in very narrow strategies. So just direct lending or just private equity. And really the catalyst was software and AI. And also some of the market volatility, but starting to question the quality of their portfolio. Or it could have just been market volatility because of what's going on outside of this where people want their money back. There's a limit on how much money people can ask for. And basically, in the perpetual private BDC space, the amount of money people have asked for has exceeded what is the 5% limit. And that's creating all the noise that you're reading about. [00:00:00] S0: What's the range of so what's here? I can imagine one so what is like, "Tough shit, you can't have your money back," and the world keeps spinning. Another is something dangerous and scary and systemic because past financial crises have tended to be downstream of some domino, like private BDCs or whatever it is. Each time it's different. What do you think the range of implications of all this is?
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: What's the range of so what's here? I can imagine one so what is like, "Tough shit, you can't have your money back," and the world keeps spinning. Another is something dangerous and scary and systemic because past financial crises have tended to be downstream of some domino, like private BDCs or whatever it is. Each time it's different. What do you think the range of implications of all this is? [00:00:00] S1: I don't think this is a systemic issue yet, for two reasons. One, we're only five years into this so it's early. And the second thing, at least for now, there's a pretty strong economic backdrop. There's definitely risk to it. So I don't think this is systemic. It could turn out that way, but that's actually not what I think is going to happen. I do think there needs to be a major recalibration of behaviors, in the way that people approach this wealth channel, because if you go back to what we talked about earlier, any time society or finance system puts wealth or retail individuals next to principal risk-taking, if you look throughout history, that's where problems start to happen. Most of it's been with commercial banks because that's been the primary pillar of the finance system. But now with this new pillar in private capital, it's starting to touch risk capital, and it's starting to become more asset liability mismatched. But when you look at the quantum of the problem, at least as it specifically relates to this, it's pretty small in the grand scheme of things.
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: I don't think this is a systemic issue yet, for two reasons. One, we're only five years into this so it's early. And the second thing, at least for now, there's a pretty strong economic backdrop. There's definitely risk to it. So I don't think this is systemic. It could turn out that way, but that's actually not what I think is going to happen. I do think there needs to be a major recalibration of behaviors, in the way that people approach this wealth channel, because if you go back to what we talked about earlier, any time society or finance system puts wealth or retail individuals next to principal risk-taking, if you look throughout history, that's where problems start to happen. Most of it's been with commercial banks because that's been the primary pillar of the finance system. But now with this new pillar in private capital, it's starting to touch risk capital, and it's starting to become more asset liability mismatched. But when you look at the quantum of the problem, at least as it specifically relates to this, it's pretty small in the grand scheme of things. [00:00:00] S0: So what's going on is, in private markets, in the wealth channel, very small allocations to private investments, historically one to two percent. And that channel is smart. They see that value creation and returns are happening without them in private markets. They want access to it. Seems fair. That two percent is expected to go wherever, 10 plus percent in the decade to come. So I guess the question is, how can we do it responsibly?
· Alan Waxman
[00:00:00] S1: If you are going to raise a narrow strategy, just direct lending or just private equity, you need to govern the amount of inflows that come in. So sometimes you just say no. Maybe you have a waiting list. But again, because flows come in in procyclical times, if you only have a $100 million vehicle, maybe it's always a good time to invest. But if you have a much larger vehicle, it just gets really hard because maybe it's a good time to invest, maybe it's not. And that's why I think where this will go responsibly, I think you're going to have to have very wide apertures, because ultimately in every ecosystem, whether it's direct lending or private equity or real estate or infrastructure, they go through supply-demand dynamics. Sometimes supply of capital is really high and demand is low. That's probably not a good time to invest. And sometimes demand of capital is really high and supply of capital is really low. Again, not certainly, but probably a pretty good time to invest. And it oscillates within each ecosystem all the time. So I just think you want a wide aperture. But if you're going to do that, you can't just all of a sudden show up, which is probably what's going to happen after this week. Everyone's going to show up and say, oh, I'm a multi-strategy private capital fund. I'm going to do whatever. Well, yeah, you got to be able to do it, but you also got to have the capabilities to be able to do that. And there's a number of people that do, but you can't just all sudden do it. It's like a style of investing. And I think those are the key attributes that will make up responsible investing. But I think the biggest thing is just being very upfront. When you want your money back, you have to assume it's a 2008 crisis, 1929. And if you're comfortable keeping it invested, then you're probably a suitable investor.