When will the ‘good times’ end and how do you avoid crashing with the market?

The financial crisis of 2008-2009 was not just a recession and a market crash; it was exacerbated by a banking crisis and a housing crisis. It is highly unlikely that the next crisis will be formed in the same way. Banks have shored up their balance sheets globally and particularly in the United States. Households have deleveraged and credit standards for mortgages have improved. 

How, then, might the next crisis emerge? We hear from Lauren Goodwin, Director of Portfolio Strategy at New York Life Investments and speaker at SuperReturn US West, as she explains the risks that could soon appear in the market and ways to avoid crashing down with it.

Why has capital flowed to private markets?

Investors are increasingly concerned about conditions in private capital markets. Throughout the post-crisis economic expansion, capital has flowed to private markets for several reasons. Regulators have required banks to be more disciplined about leverage on their balance sheets, creating tighter credit conditions and thus higher demand for financing from other sources. At the same time, a slower economic recovery and low-for-long interest rates contributes to higher valuations in public markets, increasing demand for higher-yielding private assets.

Now, an increasing proportion of the investment “pie” is being apportioned to private markets. This raises the overall capital base, contributing to higher private equity valuations and increasingly permissive private lenders.

What are the risks?

While capital inflows to private markets provide substantial investment opportunities, they also create risks. A bigger share of corporate financing has been brought outside of the regulatory purview, making it harder for regulators to keep tabs on the market. This concern is exacerbated by the presence of leverage; leverage amplifies return as prices rise but can exacerbate uneasiness in the system as valuations or operating performance decline. If an economic downturn occurs and defaults start to rise, capital could dry up, leaving companies nowhere to go for refinancing and triggering even more defaults.

There is little evidence of strain in credit measures currently. Liquidity growth has been ample and default rates are low. However, a few key developments leave us concerned that risks could be higher than some investors appreciate:

• Lenders are now leveraged vehicles. In previous cycles, insurance companies and prime funds were the dominant lenders in the private equity marketplace. Now it’s vehicles loaning the money – leverage on leverage. This could present a risk, particularly where the size and distribution of exposures are uncertain.
• Tools for monitoring crises have shifted. As more company financing has moved from the banking sector to private financing, it has also become less transparent. Market-based indicators thus do not account for the large proportion of deals that have moved off bank balance sheets. Comparing today’s leverage levels to those in the pre-crisis period may give a false sense of security^[1].
• Heavy competition means sponsors and general partners are sacrificing important due diligence. This is particularly worrisome because earnings before interest, taxes, depreciation, and amortisation (EBITDA), a measure of operating performance and a focus of private markets’ valuation, is mired with accounting tricks requiring careful investigation.
• The economic cycle is nearing its end…. Revisions to national accounts data throughout 2019 revealed that profit margins have been losing steam since 2014. Admittedly, low interest rates alleviate some cost pressure, but we doubt that reduced interest cost itself is enough to boost profit margins in the face of higher labor costs and structural shifts. The resulting thin margins makes companies more sensitive to risk.
• … and risk distributions have wider tails. Higher leverage levels in private equity buyouts contribute to swings in economic cyclicality, magnifying the effect of economic shocks^[2].

What can investors do to avoid the next downturn?

Dislocation in the private capital markets is likely to contribute to the next recession. The availability of easy money and the accompanying risky behavior was a primary contributor to the 2008 financial crisis and should be a red flag going forward.

What can investors do to avoid the crash?

• Minimise liquidity risks. None of us has a crystal ball to say when the cycle will end. Still, the longer the cycle lasts, the more chance there is for excess to build. Be mindful of deal structure. If leverage is desired, apply it to higher-quality, shorter duration credit, and via managers with a proven track record.
• Respect the cycle. At this stage of the game, de-emphasise industries whose demand is impacted by ebbs and flows in the economic cycle.
• Maintain capital base. Available capital increases agility in down markets and empowers funds to say “no” to bad deals.
• Relationships still matter. Strong relationships and reputation help create vital access to the best deals. Admittedly, disintermediation of lending sources and expansion of private loan size is making deal access more challenging in private credit, but it’s still important.
• Invest in what you can control. Manager dispersion is wide, particularly in a cycle that has lasted this long. Invest where sponsors have proven expertise, as well as a clear and controllable value creation thesis. Unusually high return estimates should be seen with skepticism, particularly late in the economic cycle^[3].
• Re-evaluate strategic allocations. From an asset allocator’s perspective, higher valuations in private equity mean that the illiquidity premium offered by the asset class has eroded. While absolute returns are higher than in many asset classes, traditional risk-return based approaches tend to ignore the impact of manager dispersion and artificially smoothed index returns. Asset allocators should incorporate these realities into their portfolio construction process^[4].

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^References:

^{[1] For another example, see Nina Boyarchenko, and Or Shachar’s piece, “What’s in A(AA) Credit rating?” from Liberty Street Economics, January 8 2020.}

^{[2] For further details, see “The Economic Effects of Private Equity Buyouts” (2019) by Davis, Haltiwagner, Handley, Lipsius, Lerner, and Miranda.}

^{[3] These insights were shaped with the generous support of our colleagues at Private Advisors and GoldPoint Partners.}

^{[4] For specifics, see my colleague Amit Soni’s white paper, “Performance Dispersion Risk Assessment in Alternatives and Active Strategies.” Journal of Alternative Investments, Spring 2020. https://jai.pm-research.com/content/early/2020/01/29/jai.2020.1.088}

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