Sunday, November 05, 2006

Observations on Risk-Don't Confuse Liquidity with Brains

As my profile indicates, I have been in this business for more than 25 years, in fact come April, it will be thirty years. I suspect I may be one of the older bloggers around, but I still look at myself as someone who still has a long career ahead, God -willing. I would love nothing better than continuing to come into my office well into my golden years, following the examples of Buffett and Munger, or others you may not know such as Irving Kahn, or Roy Neuberger. Despite many years of experience, having influenced billions (yes with a B) of dollars of assets, having faced numerous investment committees, and many individual clients, I still view myself as someone who is still involved in continuous learning. I would far rather think about an investment issue, or read a 10-K or Q than watch most sporting events...a tough admission for a guy, but a very honest one.

What makes a good portfolio manager? In my view, there is a passion for excellence and learning. But most importantly, there is an appreciation of risk. The investment management business has a very long apprenticeship, perhaps longer than any other occupation. An appreciation of risk from what I see, is innate rather than taught. Being able to think in probabilities of outcomes with a respect for the downside is not just a mathematical exercise, it should be practically a reflex action from a good portfolio manager.There have been times during my business career when risk capital was in very limited supply. For example, in 1982, I can recall seeing investment pools that were supposed to be fully invested with cash positions of 40%! Though prices kept getting cheaper, it seemed that no one was interested in taking on the "risk" of the market. Yet, in retrospect, the real risk resided in not being in the market. Risk aversion for me and other value buyers was overcome by great prices.

Risk aversion unfortunately tends to get thrown out the window by higher rather than lower prices, by exotic instruments rather than traditional ones, and by mystery and intrigue!Risk aversion was defenestrated in the Internet phase of 1999 and 2000. Despite wonderful opportunities that existed in the decent stocks that were being dumped to provide the fuel to accumulate the crap, the desire for more risk overwhelmed most investors. Boring and decent was traded for excitement and lure.

Since that time, investors just can't seem to get that excited about equities. Though long term returns of 11 and 12% seem like impossibly high annual returns for the long term, those kinds of returns were the basis for many financial projections by financial planners. Now, most planners seem to have a tough time forseeing conclusion above 7%. Many clients find that conclusion less than satisfying and inadequate.

Unfortunately, this has resulted in stretching for returns. Stretching for returns generally means assuming more risks. The willingness to undertake new, unproven, and risky investments seems very high at the moment. The skepticism and apprehension that ordinarily causes vacillation and reluctance in many investors also seems to have gone by the wayside. In short, when it comes to hedge funds, to private equity funds, and to buyout funds, the usual insistence on high risk premiums is absent and the willingness to accept greater risk is strong.

When I consider some of the buyouts that have taken place this year, some of them which benefitted my clients as well as myself, I shudder to think about how these businesses will look when they come back to the public market. Please read my views on the Yankee Candle proposed deal. Similarly, Aramark (RMK,) Macdermid (MRD,) Petco all have either gone away or are going to buyout funds.

What an irony! If prospective returns on public equity are considered to be so substandard and below historical norms, that they are considered unexciting, how is it possible that the buyout funds can buy these companies at takeout premiums, charge huge fees, and generate superior returns to those available in the public equity markets? Combine that with greater competition for deals amongst the buyout firms and a consequent need to pay ever higher multiples and it seems that high buyout returns are history and are unlikely to repeat themselves, at least from current market valuations. How can it be possible???

Admittedly, there is magic in creating debt leverage. Running companies harder with thinner equity cushions heats returns. Unfortunately, recession or high interest rates also force these heated results into the pressure cooker.A great deal of liquidity and friendly interest rate environments have made a huge contribution to the wealth of many buyout dealmakers. If liquidity becomes grudging, highly leveraged transformations of previously sound balance sheets will face a sordid future. Finally, the dependence on creating some sort of public equity transaction as an exit strategy becomes unassured.

Witness how quickly some operators want to get out of their deals. Leonard Green et al got out of their FTD deal in a year. The folks who bought (or perhaps stole) Hertz from Ford are taking their investment out in 11 months.

Equity markets are not always that willing to help in the rescue. Streamlining of operations works best in expanding economies and floating rate debt cannot always be swapped into fixed rates when credit cycles are stingy.Don't succumb to the lure of past returns. Don't confuse returns with brainpower. And don't forget that buying businesses without a margin of safety will bite you in the butt eventually. Today's darlings of the buyout world will ultimately disgrace the capital markets and disappoint their investors.

Disclaimer: I, my family and some clients have a current position in Yankee Candle. Certain clients have a current position in Aramark and in Macdermid. None of us owns a position in FTD.


At 10:02 PM, Blogger RichL said...

I've been in the business a while, and am similarly inclined. The first place I worked in Wall St. was at a firm where the name partner had formerly owned a sweater factory in the garment district. His prior experience served him well, as both are fashion businesses. The past few years have been quite profitable, but how much can one reasonably expect to mark up the price of the sweaters? There are better buys in the bigger names, but that is not going to get you rich. The private equity guys will get publicity on the homeruns, but, IMHO, at these prices, buying illiquid positions at high prices is not a strategy for capital gains


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