At the 2018 Milken Institute Global Conference one common refrain from investors and dealmakers was as follows: The world is awash in cheap money chasing a finite supply of good opportunities. Prices on everything from high end real estate, to corporate bonds and stocks, are at nosebleed levels.
And yet, in listening to just a handful of the conference’s dozens of panels, where leaders in investing, business, politics and science offered their insight, many trillion-dollar ideas in finance emerged. Capital is not in short supply, in fact some say it’s become "commoditized." Still, a number of insiders are spotting big, often contrarian opportunities that they are capitalizing on, or where new money can be invested with productive use.
The New Future For Hedge Funds
Take Andrew Feldstein, co-founder and CIO of BlueMountain Capital. He articulated a novel survival strategy for the $3 trillion-plus hedge fund industry, currently in doubt as institutional investors flock to higher return private equity or lower cost passive strategies.
Feldstein’s over $21 billion in assets firm has long been known as one of the smartest credit investors on the planet, but in recent years, BlueMountain has built a presence in everything from to systematic trading strategies across assets to quantitative analysis. Feldstein tipped his hand to peers that BlueMountain will soon be investing heavily in healthcare, spotting a "massive transition” in the demographically booming industry. But it was the structure of hedge funds where Feldstein had the most compelling idea.
To demand high fees, Feldstein rightly argued funds need to stay at the frontier of the investing world, uncovering the "alpha" that should make funds worth their cost. Of course, this an expensive proposition. It involves technology infrastructure, talent, and heavy investment in new tools like data science. That's a tough ask for funds who are now constantly worried about redemptions and hesitant to reinvest in their platforms. How can one spend $50 million to build a quant specialty if LPs could abandon them a year later? Feldstein’s solution: Offer big institutional investors lower fees – goodbye 2 & 20 – for longer term five-to-seven-year lockups. In this format, the LP would be investing with a long enough duration that the fund would would have the confidence to invest in its own alpha-hunting business.
What Feldstein articulated was changing fee structures so that LPs looked at their investments as a mutual partnership. Their committed long-term capital could help generate “network effects” of knowledge - and alpha -- that flows back into their pockets. Think of management fees, or performance fees, as a direct investment in the fund platform. “The firms that succeed are going to be the ones that figure out how to scale without losing their innovation,” Feldstein lectured. “If you don’t stay at the frontier [of the investing world] you’ve become a commodity return provider… You want us to be continually pushing the boundaries.”
Junk Bonds 2.0
The conference is an annual reminder of the awesome power of Michael Milken’s insight that non-investment grade companies and new entrepreneurs can be financed in a way that would yield above average returns to investors. That idea spawned the private equity industry and the junk bond market. Now, the innovation is somewhat commoditized. The zero-rate world means the S&P High Yield Corporate Bond Index carries a yield of just 5%. Investors can now also gain exposure through low cost ETF wrappers and indexes. However, for insurers and pensions promising to cover long-term liabilities, it’s created a headache. Coupons on today’s junk don’t pay for tomorrow’s commitments.
Here another innovation is emerging, articulated by Apollo Global's CIO of credit, Jim Zelter. Apollo has built an over $80 billion in assets insurer called Athene, which is beginning to take on the commitments of life and annuities providers. It creates fixed income portfolios that earn well over 5%, by constructing portfolios with liquid corporate bonds and higher yielding derivatives such as residential mortgage backed securities, structured credit and mortgages.
“The areas where we can add value are in RMBS, ABS and mortgage loans, which are around 35% [of Athene’s $82 billion balance sheet],” said Zelter. “We really want to create a business that is almost like the GE Capital of tomorrow,” he told a room of credit gurus. Apollo, one of the world’s largest PE firms, is among the heaviest issuers of high coupon debts like leveraged loans that Athene is buying to solve its portfolio yield challenges.
“From our perspective to create opportunities, to create origination and balance that origination with buying things from the sell side is how we happen to have a role,” Zelter said, “If you count on Credit Suisse or other great firms to create product you are going to be a little disadvantaged.” Taking share could be the next great growth market for alternative managers like Apollo.
Apollo competitor Blackstone is pushing into the insurance business, spotting the opportunity Zelter articulated and has begun capitalizing on. Earlier this year, co-founder Stephen Schwarzman called managing insurance assets a many trillion dollar opportunity. Said Schwarzman, “there is an estimated $23 trillion, that's with a T, of insurance assets globally, a vast largely untapped market for us and for just about anybody else, except strictly high grade sellers of product.”
Mr. Market’s Existential Problem
The money’s flowing and valuations are surging, but smart minds find something’s off. In fact, the billions flowing into private equity funds these days could be a blaring red sign of trouble.
As David Hunt, CEO of PGIM, the $1 trillion in assets investing arm of insurer Prudential , explained: “Our equity markets actually are not in good health. We have now literally half of the public companies we had fifteen years ago. The level of IPOs is at an all-time low despite all of advances that are being made in technology. At the same time private equity is raising more money than they have before.”
Why? CEO’s say life on public markets is becoming too tough to handle, even as stock prices (and compensation) soar. There’s the pressure to make the numbers each quarter, so CEOs say they can’t implement long-term growth strategies, otherwise they risk being fired. And who are their shareholders? Passive funds that have little true knowledge of the business. The active managers who remain in markets and invest in companies are being squeezed, some can hardly hold on.
According to Hunt, this all looks like treacherous waters for American companies, who are either remaining privately-held ventures, or becoming private equity portfolio companies.
“Effectively the equity slice of the American economy is increasingly being owned by private equity and not by public investors,” said Hunt. He argued share gains are due to PE's advantaged "structure that can absorb illiquidity better than the public markets.” He added, “We’ve had a social contract that individual investors would have an ability to invest in fast growing technology companies. They are not anymore. Those companies are staying private. That is a real issue for us as we look at the equity market.”
How can the 10-year horizon that has worked wonders for PE be brought to liquid public markets? It’s the big question for today’s shrinking stock market.
The Housing Part Of America's Next Big Dig
The most somber panel I attended was titled: American Home-ownership: Do We Still Have A Dream? and featuring mortgage bond pioneer Lewis Ranieri and Fannie Mae head Timothy Mayopoulos.
In it, there were two alarming charts. First: New home construction since the crisis has been skewed 75% to high end real estate. Among the existing stock of home rentals, only 18% is affordable housing. Put differently, there’s a shortage of affordable housing and no one’s building it. No surprise, a second chart showed the troubling consequence: From 2011-2017, low tier home prices in America’s biggest cities have surged multiples of middle and high price homes. As bad as affordability is it’s only going to get worse. That was the message Fannie Mae’s Mayopoulos wanted to hammer home.
“Despite what people think, all the studies that we do at Fannie Mae do not suggest that Millennials want to rent. They aspire to own homes at the same rate as prior generations. Whether they will be able to act on that aspiration is another thing. This challenge is only going to get greater as this very big pig goes through the snake because Millennials are going to put this huge pressure on this first-time home buyer segment. It runs the risk of running up these prices even higher.”