We typically write-up a full investment market and portfolio update at the end of each quarter, with a more interest-related post at the mid-quarter mark.
For this mid-quarter post, our Alternative Asset Manager, Louis Frank, has written up an interesting piece on the difference between private equity and private asset-backed investments.
However, given recent public market volatility, we have also included a section at the end with a high-level public market update.
As always, we are carefully watching and managing client portfolios daily.
Jay Gould was an American railroad magnate and a controversial robber baron of the American industrial revolution.
His straightforward and often unscrupulous methods of investing made him one of the wealthiest/notorious investors of the mid to late 19th century.
Gould’s personal investment into US railroads and telegraph companies were seen as early private investments (however long before the mainstream coined it “private equity”).
These early investments set a historical precedent to the wealth that private investments can generate for investors.
Fast Forward to Today
Investors have been acquiring and making investments in private companies/assets for over 200 years.
While in the traditional sense, private equity has focused on investing in specific enterprises or companies, the realm of private investment now spans many different strategies and assets.
Today, private investments (or alternative assets) may include hedge funds, farmland, real assets, asset-backed lending, and cryptocurrencies, to name a few.
LotusGroup specifically focuses on asset-backed (or real asset) private investments for our clients.
So why focus on asset-backed investments?
Outlined below are some critical characteristics between traditional private equity and asset-backed investments.
What is Private Equity (“PE”)?
As mentioned earlier, private equity is a generalized term to describe money pooled by funds to acquire stakes in private companies.
While there are many sub-sectors of PE, it is most often associated with funds searching for mature and revenue-generating companies that are looking to be further optimized.
Fund managers may replace the management team of an acquired company, redesign internal processes, cut product lines, or redesign a company’s marketing strategy (among other approaches).
The ultimate goal is to unlock value and position the company for a strategic sale or a public offering to “exit” or monetize the improved investment.
PE managers focus on several different sectors and often offer opportunities for many different investors/risk profiles.
Asset-backed (or real assets) investments have become increasingly popular in the last 20-30 years.
These are investments into portfolios or individual tangible assets (such as machinery) or real assets (think cell phone towers or a single-family homes).
Funds often acquire these assets with a focus on immediate cash flow, and then often work to stabilize/provide value-adds to unlock further value.
These assets often inherently offer a level of downside protection, with many managers knowing that the underlying assets should hold value (in good or bad economic times).
Why focus on asset-backed investments?
As a baseline, all alternative assets possess some level of risk.
Risk can appear operationally, in the management team, with financing, in the industry, from a regulatory perspective, or in the worst case as fraud.
However, PE also offers opportunity and risk in regard to a more variable equity multiple.
PE funds often rely on strong sales and profit growth to drive valuation multiples.
As such, these investments are more sensitive to a cyclical economy and to a manager’s skill at driving higher or lower profitability.
In a rising tide, this can drive values dramatically higher.
However, when economies and industries hit a recession, PE can contract much more as well.
These factors often make PE investing more enticing at the beginning or middle of an economic cycle and less attractive towards the end.
While the above scenarios/risks may apply to asset-backed funds as well, there are a few crucial differences:
- Underlying assets are tangible or real and tend to have a lower volatility profile during recession
- Assets can be tied to creditworthy tenants with long-term contracts
- Assets often are income-producing with long-term contracts, which helps blunt any valuation declines
- Inflation is often a positive for assets as it helps their values rise, while inflation can hurt PE with high input costs to production
The above traits help make asset-backed strategies more conservative than traditional private equity.
As such, our investment team has focused heavily on these assets to generate late-cycle returns for clients while also diversifying portfolios.
Please do not hesitate to reach out to our team to discuss the above topic in greater detail; we welcome the conversation!
LotusGroup Alternative Asset Manager
High-Level Public Market Update
Markets have recently pulled back from all-time highs as coronavirus fears have resulted in human quarantines and disruptions to global supply chains.
Consumer demand in Asia and Europe has been strained as government health officials have asked citizens to self-quarantine and business / tourism travel has dramatically declined.
Additionally, global supply chains providing goods and services have been disrupted.
For example, many idled Chinese manufacturing facilities are struggling to supply new parts and equipment to consumer electronics companies.
Domestically produced goods and services in the US have had fewer disruptions to-date, given the very few cases so far in the US.
However, strains have appeared for companies and products that are reliant on global supply chains (e.g. Apple iPhones).
Additionally, there could be another phase of disruption in the US if more cases begin to arise in our homeland.
One other reason for the recent public market declines is simply a correction of overly abundant positive investor sentiment.
Markets surged to new highs in 2019 and early 2020, despite very lackluster revenue and earnings growth.
Such market resilience resulted in investor’s complacency and a desire to chase after new-highs, particularly in high-growth stocks with feel-good stories.
For example, Tesla stock more than tripled in a parabolic move from under $300 to over $900, predominantly driven by huge future expectations and a heavy short-squeeze.
In hindsight, these moves were not entirely based on fundamentals, and a market correction was building.
Below is a chart from our paid-for data partner Ned Davis Research.
We look at this information weekly, and it currently flashed an excessive investor sentiment reading before the recent market correction (see bold circles on right side of charts below).
As it pertains to client portfolios:
- Index clients enjoyed an above average year of return in 2019 and understand that not all years can look the same. Such investors are well-suited to behaviorally focus on the long-term upward trend, while not being overly concerned about near-term market overreactions either higher or lower. As per our playbook, we continually look for opportunities to rebalance these portfolios, systematically taking money off the table in areas that have gone above allocation while redeploying those funds to areas that have gone below allocation. While we were selling stocks at highs in 2019, we will look to buy stocks in 2020 if market declines take allocations below targeted levels. This approach systematically helps the portfolio buy low and sell high, while keeping the overall allocation within balance.
- Global rotation clients also had a very nice year of above-average returns in 2019. However, we have kept these portfolios at a lower beta to the public markets given our investment model readings of an overvalued market. Investors in this strategy are well-suited to behaviorally focus on the long-term upward trend within a fully deployed portfolio, but also enjoy our ability to adjust portfolio beta either up or down based on our investment model readings. As such, our current lower beta position in these portfolios have resulted in smaller and more muted declines relative to markets. While we are currently in a protective mode with these portfolios, we are looking for value opportunities and a window to add risk through these declines.
- Tactical clients have become accustomed to our more conservative positioning in recent years. While these clients enjoyed positive returns in 2019, they were more muted relative to the high-flying public markets. Investors in this strategy are well-suited to behaviorally be patient when markets are overvalued and over exuberant, while asking us to be more aggressive when the opposite environment arrives. Currently, our tactical portfolios have been protected the most from recent declines, with a measure of cash and some volatility hedges in place. We will continue to monitor valuations and market sentiment, with the focus on protection and an eye towards future opportunities to buy the dip.
As always, we continue to vigilantly monitor and manage client portfolios daily.
Please reach out to your LGA Private Client Advisor if you have any questions about the markets or your portfolio strategy selection and positioning.
Public Markets Investment Manager