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The Death of Liquidity

The move to private markets comes at a cost.

The views expressed here are those of the author and do not necessarily reflect the views of Morningstar.

Financial markets are complicated because they have the aspects of a game, but a game that has a great many rules, and the rules keep changing. One of the most important rules of financial markets has been the principle of liquidity. In early times, financial transactions were between landowner and farmer. The landowner had all the power. The farmer could survive as long as crops were good, but when the crops failed, the farmer became a slave or serf and the landowner became a feudal lord. One example of this process took place about 3,000 years ago when the family of Jacob, pastoral sheep owners, migrated to Egypt to escape a drought. They ended up slaves in Egypt. You may have seen the movie.

The First Liquid Asset
In those days, the main use of finance was a form of venture capital when the king would borrow, say, 2,000 marks to pay for a war against the king next door. These loans were bad deals for the lender because he ended up with an undiversified portfolio. If the lender could have financed both kings, he would have had a chance to get one of the loans repaid and, if the interest rate was high enough, have his bank survive. However, all of these medieval banks eventually failed because the king would just repudiate the debt.

Modern finance was invented in Venice in 1172. The Venetians needed to raise a lot of money to ransom their merchants who had been imprisoned by the Byzantine emperor. They forced all the wealthy men of Venice to put up the money, but they in return gave a 5% perpetual bond to the forced lenders. These bonds, or prestiti, were transferable, so a financial market sprang up to trade the prestiti in the Rialto Marketplace.

The first liquid asset in history was money, which really made trade possible and simplified everyone’s life. It is much easier to run the tax office if the systems pay you in silver coins rather than live goats. The new prestiti were more suitable for large transactions, so foreign trade, the lifeblood of Venice, became much simpler. The prestiti were very attractive to the buyer because they paid interest and were fungible because they were standardized and, therefore, investable. Liquidity had been invented. In earlier times, a loan would be made from a family bank to a king. The borrower was the king himself, so the loan was not collateralized by the kingdom. If the king died or changed his mind about repaying, the lender was out of luck. As a result, interest rates throughout Europe were very high, in the 20% range. Venice, raising money through a liquid security, could do it at 5%.

Negative Liquidity
For the next 900 years, liquidity was considered to be a key consideration by investors. In the past few years, many institutional investors decided that liquidity could be disadvantageous. They switched a great deal of their portfolio into hedge funds with limited liquidity and private equity funds that have negative liquidity. What do I mean by negative liquidity? These funds make distributions when it suits the fund manager, not the investor, and the fund manager has the right to call for additional investment at his option, not the investor. When you give someone an option of this nature, it has substantial value, but the private equity fund doesn’t pay for it.

Many institutional investors like a private equity fund because the valuation seems very stable compared with their liquid investments, which fluctuate with the level of the stock market. However, the private equity manager prices holdings by an arbitrary algorithm (such as “8 times adjusted EBITDA”) that appears not to adhere to the vagaries of the market. The valuation is only a convenient fiction.

What happens to an endowment or pension fund that decides to put 20% of its assets into an illiquid fund? For the first year or two, not much, because the private equity fund hasn’t gotten around to calling the money yet. But as the capital calls are made, the liquid securities diminish, and the illiquid ones increase. Then at the end of the year, the institution will distribute about 5% of its assets as an endowment draw or a similar amount to the pension beneficiaries. These draws will be paid out of the liquid portion of the portfolio because the illiquid portion is, well, illiquid. As this goes on, the liquid assets start declining rather rapidly. If something bad happens in the market, people who need the money, to pay the pensions or endowment draws, are going to have to sell the public stuff quite rapidly.

The Move to Private Markets
If you have been involved with institutional investing, such as pension funds, foundations, or college endowments, you have been pitched to move away from marketable assets, such as stocks, bonds, and mutual funds. The money is going into “private markets.” Hedge funds, commercial real estate, forests, venture capital, and private equity pools are all popular.
Why? High returns.

In the investment world of 15 years ago, institutions were led to believe that their money could produce 8% per year with moderate risk. In fact, it was easy. You could do it with a stock index fund, a bond index fund, and a spreadsheet. Set the stock/bond ratio on day one, and let the profits roll in: 10% return on stocks, 5% on bonds, 60/40 split, and portfolio returns are 8%. The endowment can distribute 5% and keep up with inflation. The only value added by the portfolio manager was to negotiate management fees from 20 basis points down to 10 basis points.

Except it didn’t work. Stocks got mashed in 2008, and government-bond yields dropped to zero. In Europe, yields went below zero. When I took economics (a while ago), the class was assured that interest rates could not go below zero because no one would buy an investment that could only lose money, but it happened in several thought-to-be rational countries. Anyway, your spreadsheet calculation was hopeless. If the 40% in bonds earns zero, to make 8% total your stocks need to return 13.3%, and that is not believable for an unleveraged liquid portfolio.

What can you do? First, you can relax the “unleveraged” constraint. Hedge fund managers promised positive alpha, which few could deliver net after their high fees. They could produce beta returns as long as stock returns were high, but beware when they start to descend. The other choice was to monetize the “liquidity” risk premium on stocks. Private equity funds bought into illiquid private companies at low prices and then, through the magic of IPOs, resold them at liquid high prices. That strategy worked much better than hedge funds, even though private equity funds charged high fees, too.

Degree of Difficulty
There is a lot of thought about the suitability of private equity to the buyer in terms of return, risk, and liquidity. There are other players in the private equity game besides the institutional buyer. The private companies that want to sell equity are necessary, but their motive is obvious: raise money or go bust. The private equity fund managers have a related plan, trying to get a deal done and generate a big fee, afraid that if the financing doesn’t close, they will lose their job and go back to living in mom’s basement. There are others, such as your fund’s new outsourced chief investment officer, or OCIO. Few endowment funds or foundations have an in-house fund management capability, so the fund board hires outside management. The OCIO has a group of professionals who understand investing, know how to set up plausible portfolios, use their marketing skills to get clients, and who then figure out how to perform customer retention.

To keep a client impressed, it doesn’t take long to figure out that you cannot make it with a portfolio of a couple of index funds and a buy-and-hold strategy. The job is not hard enough. Why is difficulty important?

Compare portfolio management with some other games of skill. First, chess is famously difficult. Who is the world chess champion? If you know, you may feel some pride. But you probably don’t know and may feel that you should, because a chess champion’s name is worth remembering.

Then, there’s checkers (or draughts, as they call the game in Great Britain). Who is the world champion of this popular game? I would be surprised if any of you readers know the answer. But you don’t care, either. Checkers is a simpler game than chess. You would be more likely to know who the secretary of the interior was during the Warren Harding administration than the name of the best checkers player. I had to Google the answer.

Our third game is tic-tac-toe. The champion? A witless question. You can teach a child to play perfect tic-tac-toe in an hour.

(Note: The chess champion is Magnus Carlsen of Norway, or the Stockfish computer program. Checkers champ is Alexander Moiseyev. Interior secretary in 1921 was Albert B. Fall, of Teapot Dome infamy. Tic-tac-toe, your grandchild.)

If you examine your own feelings about the three games, it is clear that success in a complex game is more valued than winning a trivial game. Being the best private equity manager is more valued than just deciding between two S&P 500 index funds. The OCIO can claim to have a remarkably skilled private equity team, which the customer will admire and will agree to fund a private equity portfolio. At this point, the OCIO has won! Once clients start funding private equity, meeting capital calls that make up an important part of the total portfolio, they are in an illiquid asset. If clients later want to sell their position, it can’t be done except at a heavy discount, if at all. Firing the OCIO would be extremely expensive and time-consuming. Customer retention has been achieved.

Real Costs
But for what future investment result have you been retained? A private equity commitment has real costs, starting with delay. If you agree to invest money in some stocks, the new buys start generating return immediately, while an agreement to put money into a private equity fund only gives you a spot in the queue for the next capital call. Usually that capital call will be for a fraction of your commitment, and it can take five years to get fully invested. You have granted a long-term call option to the private equity manager—for free. The manager will tell you about the high return you are making on the small capital you put in the first year, but he or she will not report it as a return on your commitment. This return figure is called an IRR, which is an acronym for Imaginary Retrospective Return (non-GAAP). The retrospective adjective is included because the IRR measures what you would have made on your capital if you had started the program five years ago.

Private equity did produce big IRRs over the past 10 years, enough to make most big institutional investors sign up for more. The backlog to put money into private equity is called “dry powder” (a term having to do with shooting flintlock muskets and, therefore, frequently used by militiamen in midtown Manhattan). The powder magazine at the end of 2018 held about $1.2 trillion waiting to be called ahead of you. That is double the amount of gunpowder in 2008. Because of the demand for deals, the price of deals (as measured by enterprise value/ EBITDA) has risen from a ratio of 6.9 in 2009 to 9.6 at the start of 2019. A crowded trade?

A gentleman trying to sell a fund I run a private equity program thought his best pitch was that private equity had been the most profitable asset class over the past 10 years. I interviewed an investor who had continually put money into the asset class that had been the best over the previous decade. We had a nice chat, after which I gave her five bucks for bus fare. More factually, Credit Suisse found that for the past five years the spread of private equity returns over the MSCI World Index had just gone to minus 1%.

Private equity is not going to disappear. But when returns disappoint, investors may find that they miss the liquidity of stocks and mutual funds.

The problem is that students can use the Internet to find the lowest-price education and easily select the best deal. The economist calls this “price discovery.” Retailers call it “Amazon.” Retail stores tried to cut costs, but they are vanishing. Colleges are feeling the same pressure and are trying the same solutions of cost-cutting and productivity improvement, but that may not help Syracuse any more than it helped Sears.

Government money and regulation can do a lot. Changing the student loan rules would make a difference, too. In the meantime, increased alumni support will extend the time that your college will survive until trends change. So, send in some money.

This article originally appeared in the Summer 2019 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.