Investing is such a strange animal. You can be wrong and still make money. You can be right and still lose money.
I have been wrong on high yield bonds for the last couple of years. I didn’t like the energy component of the space. Oil prices were falling due to the shale revolution and it looked like companies that had sold bonds to make ends meet were overextended. I feared that just a couple of bankruptcies could spread to the entire high yield space, dragging everything down.
That didn’t happen. Despite some private equity funds over-reaching, the space mostly adapted to low oil prices by cutting costs and developing technology to get oil out of the ground more efficiently. Investors continued to buy up high yield bonds in a chase for yield.
I was wrong, but I’m happy to take the L on my record for this one. Piling into high yield has meant a return of about 8% over the last year while much of fixed income has been flat. Missing out on an extra 8% return sounds less than ideal, but where would I have been pulling the money for that investment? Does it make sense to chase yield or the hot sector by pulling from fixed income, an allocation meant to protect the portfolio? Selling the boring stuff would have compounded the pain if high yield had taken a nosedive. Equities have been up double digits so pulling from that area would have resulted in a relative loss. I’m happy to miss out on some marginal gains while passing on what I viewed as outsized risk.
This brings me to private equity today. There are fewer and fewer public companies. Tech companies like Uber don’t see a reason to go public when they can tap seemingly unlimited funds privately. There is enormous appetite for tech branded investments as evidenced by Tesla’s recent bond issue. Oversubscribed, but possibly over-hyped, the bonds now trade for less than par. Blue Apron and Snapchat have been beaten up after IPO and savaged in the media, discouraging others from going public.
With fewer public companies and the markets being driven by relatively few stocks, is private equity the place to look for equity returns now? Maybe, but this is another game I’m inclined to watch from the sidelines. Private equity funds have amassed huge stores of dry powder. That is, they have raised a ton of committed capital, but can’t seem to find anyplace to deploy it.
I’m seeing a ton of these pitches. I see the big boys and the supposedly niche plays. It’s particularly interesting getting emails from three different mezz-debt funds in a ten minute span, each touting lack of competition as an advantage.
Perhaps because of the record fundraising, it seems that private equity terms have stagnated or even gotten worse for investors. Since the financial crisis, many funds reduced their fees from 2&20 to 1.5&15 or even 1&10 almost always with reasonable hurdle rates and high water marks. More recently, I’m seeing funds moving back to 2&20 and saw one with no hurdle rate whatsoever. This is not just from the amateurs and first timers (fun to read pitches for solar-powered bitcoin miners and hydroponic marijuana farmers, though). Established private equity firms seem to be dragging their feet on shareholder friendliness as funds pour in.
Missing Out on Asymmetric Risk
Most of the investment “opportunities” that land in my email get a hard pass. The risk of things going wrong or not going right enough just isn’t justified by the potential returns. If I can get similar returns without locking up cash for years, without K-1 reporting, without the high fees, saying no is pretty easy.
The overall goal is to achieve your financial goals. There are no style points for how you get there. You’re more likely to get “there” by being wrong not chasing a marginal return than being wrong taking on outsized risk.