MONTHLY MUSINGS – MARCH 2023
FORGOTTEN LESSONS
While you might expect that each economic shock (either global or local) which happens would generate a raft of valuable lessons that are used to avoid similar mistakes in the future, this is often not the case. As Mark Twain said “history does not repeat itself, but it does often rhyme”.
This realisation and the Silicon Valley Bank’s recent implosion spurred the Roadnight team to wonder whether the lessons from:
The GFC (now 15 years ago); and
COVID
have been forgotten, and if they have, what can we learn from them?
There are many great books and articles on lessons from the GFC, but one of the best and most insightful is Seth Klarman’s investor letter in 2010 that seeks to answer this question. You can read the full letter here. We have attempted to summarise a number of the key observations from this letter, our experience with the GFC and update it for COVID and the Australian private debt market:
You should expect the 1 in 100 year flood to happen more frequently than that (say every 15 – 20 years). Roadnight’s lesson: You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse, so try to include historical worst-case outcomes in scenarios
Widespread excess liquidity (or easy money) that persists for an extended time lulls investors into a false sense of security, creating an even more dangerous situation. Roadnight’s lesson: These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses, so it is essential to assess investment opportunities with these downsides in mind. Correlation between asset classes can be surprisingly high when leverage rapidly unwinds, as shown by the “unprecedented” correlation between equity and fixed income markets over the last year.
Having clients with a long-term orientation that have a similar investment perspective is crucial. Roadnight’s lesson: An investment business without clients with a long term perspective is like a house built on sand without foundations. As a result, it is necessary to structure our investment offerings so they are not attractive to speculative capital that can be shifted faster than the underlying investments liquidate
Be wary of the consensus view or conventional wisdom – Roadnight’s lesson: the economy and financial markets are comprised of people making decisions based on their own drivers that interact in non linear ways. Given these systems' inherent complexity, the consensus view on how they will perform is more likely to be wrong than right. As a result, testing how investments and portfolios are expected to perform in a non consensus environment is necessary. A recent example of this is early 2022 consensus estimates for central bank cash rate increases around the world. These consensus estimates have been out by 2 – 4x
Ensure you are well compensated for illiquidity – especially illiquidity without control. Roadnight’s lesson: private debt investments are by their nature illiquid, so all transactions need to have controls (such as security, structure and covenants) in place that act as guard rails against taking on unwanted risks and give you a process by which you can recover your investment if they do not perform as required
Uncertainty is not the same as risk. Roadnight’s lesson: Uncertainty always exists - it is like the background noise of investing. On the other hand, risk is the likelihood you will get back the capital invested plus a return. The key with private debt is assessing if there is a sufficient margin of safety to ensure repayment of the capital advanced in an extensive range of scenarios. As a result, the focus is on assessing what it takes to impair and how the investment can be structured to minimise that happening. Any upside is a bonus.
The one thing you know about financial models is that they are wrong. Roadnight’s lesson: While reality is too complex to be accurately modelled, it does not mean you should not try. However, the focus should be on using models to understand how an investment could react in certain circumstances and what it would take to impact the recoverability of the capital invested and then have a plan on what to do in those circumstances
You must always have an alternative or backup plan ready to execute. Roadnight’s lesson: being ready in case your primary scenario does not play out involves (a) having an alternative plan ready and (b) having the capability to execute it. For private debt, this may include stepping in and enforcing the recovery of security and payments owed. If you are not prepared or capable of enforcing, you will have limited ability to recover. For Roadnight, this means always having security and either controlling that security (meaning we can make the enforcement decisions) or a pathway to doing so
A broad and flexible investment approach is essential during a crisis. Opportunities can be ephemeral, and dispersed through various sectors and markets. In such cases, rigid silos can be an enormous disadvantage.
If you’ve just stared into the abyss, remember it: the lessons of history can shape you and make you a better investor for decades.
Roadnight has built these lessons into our investment process and embedded them into our risk and compliance processes at both the investment and portfolio levels.