Eye of the beholder
Is it alpha or beta? Yes.
The compensation one can expect to receive for sporadically arranging their finance-adjacent ruminations into a free newsletter is not huge, but it’s also not nothing. Mostly it takes the form of emails from internet strangers who, for reasons that remain obscure probably even to them, have chosen to subscribe.
An exchange with one such troubled individual provided the opportunity to reflect on some of the themes mentioned in the last edition of this newsletter, published six long weeks ago.
The official explanation for that hiatus is that we observe Eastern Orthodox Lent here at Sunk Thoughts HQ, and this year the thing I chose to give up was writing. But lurking in our heart of hearts, where I store the feelings too private to confess to anyone but Greek Jesus, is another explanation: I’ve been somewhat overwhelmed recently by the weight of my own irrelevance.1
Is there anything more spiritually draining than being alive in 2023 and having no proclamations to make about the probable trajectory of AI advancements or the optimal regulatory regime for mid-sized financial institutions? Do you know what it’s like to wake up each morning and not have any particular opinion on the maturity cliff commercial real estate may or may not be heading towards?
We all have a cross to bear, but I seem to have two: being cursed to live in interesting times, and having nothing interesting to say about them.
Which is why I’m so relieved to be able to steal ideas from you fine readers. My correspondence with Theo2 started, as so many of the best things in life do, with a post about Burger King. That post used a franchisor and its franchisees as representatives of larger asset classes (public and private equity), and considered whether a person's decision to invest on the unit rather than network level could be understood in terms of tolerance for leverage and illiquidity.
Theo correctly perceived a skepticism on my part about the underlying source of investment alpha attributed to some, maybe even all, alternative asset types. The simplistic version of this argument (i.e. the only version I’m capable of making) would be that when investment outperformance is claimed, one of two things is usually happening:
The wrong benchmark is being used - A middle market buyout fund boasts that its IRR has exceeded some broad market index rather than, say, the levered portfolio of small caps that it more closely resembles. This would improperly frame the risk inherent in the investment strategy, and in a bull market, high beta strategies could falsely be claimed as proof of alpha. Still, all benchmarks are inherently artificial (why not the S&P 600?). Seeking out a favorable one for comparison is harmless marketing, no more worse than standing next to your shortest friend in a dating profile picture to look a little bit taller.
The benchmark is being ignored - This is where marketing can cross over into manipulation, which is why we never see it. Just kidding, we see it all the time and it’s great fun. Consider those lovable scamps at Tiger Global. In a year when their long-only fund of publicly traded growth tech stocks was down 67%, they made the difficult decision to write down their venture capital fund of even growthier private tech companies … 33%? Which is (checking math) less than half as much. In cases like this, the illiquid nature of the investment serves as an excuse for not even trying to value it properly.3
LPs might roll their eyes when they receive a datasheet named something like “VeryRealFundReturns_NotFake.xlsx,” but it’s not as though an endowment manager has much incentive to recognize worse performance from a fund he was probably responsible for choosing in the first place, and in which his money is locked up anyway. When lockup provisions are weaker, investors have less patience for internal private valuations that deviate from public market alternatives - see the surge in redemption requests at BREIT.
Theo is a true gentleman, and didn’t do anything as gauche as prove to me that the above points were wrong using actual data. Instead, he proposed a sort of Nietzschean revaluation of all values as pertains to measuring returns from active management:
I’ve never understood or in any case agreed with the tendency to disaggregate returns into “good” and “bad” sources. On the good side would be things like judicious security selection (for stocks) or improved corporate management (for PE and activist funds). On the bad side would be “excessive” leverage, illiquidity you’re not “properly” compensated for, or high exposure to a particular factor that “just happens” to do well. Alpha decays over time, sure, but I think that’s different from saying that every strategy that outperforms could have been replicated for cheaper in the moment.
Apologizing for his frequent use of air quotes, Theo went on to defend two features of private equity that he believes critics argue “shouldn’t count” when measuring performance. The first is leverage:
It’s like how the term “leveraged buyout” has fallen out of favor and been replaced by “private equity.” Leverage is scary and bad. Equity means ownership - aligned incentives, improved management - and is good. Every fund would like to believe it has some unique value-creating operational playbook, but the irony is the thing they might actually be uniquely good at is the thing they want to hide through the LBO to PE rebranding: leverage. It’s no accident that the Blackstones and Apollos of the world have grown huge private credit businesses alongside their buyout shops. They’re really good at debt! Lower default rates relative to other corporate borrowers back this up. So when a fund ramps up a portfolio company’s D/E ratio, I don’t think it’s as simple as plugging in a higher levered beta to CAPM and concluding that no value was created because the required rate of return has gone up proportionally.
The second feature is the illiquid nature of many private market assets. Theo writes:
I’m about at the point where I think we should scrap the whole liquidity preference theory. Yes, in theory people should be willing to pay more for an asset that they can easily convert to cash if needed. But in practice we know institutions can have rational reasons to value the opposite, namely, some pricing opacity that eases the pressure of mark-to-market and reduces the possibility of forced selling. The easier an asset is to sell on-demand, the more likely it is that you’ll find yourself in a position where you have to sell it on demand. If securitization is an example of financial innovation that increases liquidity for a given set of cash flows, maybe the growth of private / alternative investment products is best understood as the natural complement: innovation that usefully reduces liquidity. Investors aren’t being sold an overpriced and inferior product so much as paying a premium for one that’s customized to their needs.
Taken together these observations suggest that the appropriate risk premia to apply depends on the situation - not just on the investment in question, but also the investor. Now we’ve managed to back into the rather banal observation that risk adjusted measures of return will vary based on which measure of risk is used in the adjustment.4
You could be forgiven if you asked whether any of this really matters. Risk as we’ve been discussing it means volatility - historical volatility to be more precise. The future has no obligation to resemble the past, something Warren Buffett has made note of:
Volatility is not a measure of risk. And the problem is that the people who have written and taught [about risk] -- do not know how to measure risk. And the nice thing about beta, which is a measure of volatility, is that it's nice and mathematical, and wrong, in terms of measuring risk. It's a measure of volatility, but past volatility does not determine the risk of investing.
If volatility isn’t the right way to conceptualize risk, what is? Buffett again:
Risk comes from the nature of certain kinds of businesses. It can be risky to be in some businesses just by the simple economics of the type of business you're in, and it comes from not knowing what you're doing. And, you know, if you understand the economics of the business in which you are engaged, and you know the people with whom you're doing business, and you know the price you pay is sensible, you don't run any real risk.
When it’s a nonagenarian from Omaha who says this, it comes across as a folksy sort of common sense. (The full quote includes an aside about buying farmland). But as a thought experiment, imagine reading the previous paragraph and seeing it attributed to Masayoshi Son: “you don’t run any real risk” would go right up there with “not crazy enough” as an encapsulation of the whole SoftBank experience.
That gets at the Magic Eye quality of discussions about risk.
Is this a picture of an old lady, or a young woman?
When a portfolio produces a higher return than what CAPM tells us to expect, is that skill or luck? In the absence of a definitive answer5, we need a way to hold multiple images in our mind at the same time.
Granted, irrelevance is this newsletter’s founding principal.
Name has been altered to avoid the reputational risk that comes from any association with Sunk Thoughts.
From the WSJ: “Some [managers] question if public markets are a valid benchmark, contrasting the volatility of public markets with the longer-term nature of their investments in private companies.” A valid point, though one that if taken seriously by a manager of a crossover fund would mean taking advantage of stock market volatility by reallocating to public markets when multiples dip below the "true" valuations determined by whatever bullet proof methodology they apply to their venture fund. In Tiger's defense, there have been reports of the fund trying to offload portions of their venture portfolio, which could signal such a reallocation is underway.
Risk adjusted returns will also vary based on how the return itself is measured, which, as the case Tiger and BREIT show, can be contentious.
Even without following Theo to a world where liquidity trades at a discount and some forms of leverage don’t raise the cost of equity much/at all, reasonable people could come up with different required rates of return for an asset using the same asset pricing model. CAPM leaves a lot of room for subjectivity.
Different people could use different maturities of Treasuries for the risk free rate, or come up with different betas by using different time frames when measuring covariance of the asset and the overall market. They very likely might use different estimates of the market-wide equity risk premium: Aswath Damodaran has spent more time than anyone thinking about the right way to do this, and describes the process as "surprisingly haphazard."
I’m Team Old Lady.