Big Piles of Money

Q317_Pitchbook_PE_Data.PNG
Source: Morningstar/Pitchbook
Private equity is sitting on a huge pile of money. The line of investors runs out the door. In fact, private equity today reminds me a lot of hedge funds circa 2002-2005. It is the hot space. Flows have gone bananas. But will all of this money find a good home?

I am skeptical.

It is now a commonly held view that strong asset flows led to diminishing returns for hedge fund strategies over time. In general, too much money chasing limited opportunities is never a recipe for exceptional investment performance. What would otherwise be good investments become bad investments and what would otherwise be marginal investments become terrible investments.

As Seth Klarman puts it, everything is a buy at one price, a hold another and a sell at another. When a lot of money chases a limited opportunity set, prices rise. This may be good for today’s sellers but not so much for today’s investors.

I empathize with private equity investors because while there is a whole lot of money out there looking for a good home there are simply not many good homes available.

It is also now a commonly held belief that all the good companies stay private. I am not sure that is true when you have an enormous private company like Uber engaging in bizarre valuation gymnastics to manipulate its paper value. I am more inclined to argue that across the board, high valuations and easy money have turned what might otherwise be good companies into bad investments. Meanwhile, certain businesses go public that probably should not even exist if investors hope to see their capital again.

The title of this post is a play on the very well done NPR special, “A Giant Pool of Money.” (You should listen to it) The thrust of that piece was that artificially low interest rates drove investors to inflate a speculative bubble in US housing and related financial instruments, which in turn led to the global financial crisis of 2008.

Think how attractive a mortgage loan is to that $70 trillion pool of money.

Remember, they’re desperate to get any kind of interest return. They want to beat that miserable 1% interest Greenspan is offering them. And here are these homeowners paying 5%, 9% to borrow money from some bank. So what if the global pool could get in on that action?

There are problems. Individual mortgages are too big a hassle for the global pool of money. They don’t want to get mixed up with actual people, and their catastrophic health problems, and their divorces, and all the reasons that might stop them from paying their mortgages. So what Mike and his peers on Wall Street did, was to figure out a way to give the global pool of money all the benefits of a mortgage– basically higher yield– without all the hassle and risk.

So picture the whole chain. You have Clarence. He gets a mortgage from a broker. The broker sells the mortgage to a small bank. The small bank sells the mortgage to a guy like Mike at a big investment firm on Wall Street. Then Mike takes a few thousand mortgages he’s bought this way, he puts them in one big pile.

Now he’s got thousands of mortgage checks coming to him every month. It’s a huge monthly stream of money, which is expected to come in for the next 30 years, the life of a mortgage. And he then sells shares of that monthly income to investors. Those shares are called mortgage-backed securities. And the $70 trillion global pool of money loved them.

The above was reported in May 2008.

To date the underlying issue has not been resolved. As I write this the yield on the 10-year Treasury sits at 2.32%. Today the giant pool of money is not flowing into US housing and mortgage bonds. Instead it flows into private equity, high yield debt, leveraged loans and technology stocks. Plenty of it is eyeing cryptocurrencies.

But fundamentally it is doing the same thing it did in the mid-2000s. It is chasing returns.

 

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