Macro uncertainty: Mind games

Balancing a philosophy of assertiveness with the often-unpredictable realities of economics is among the most fundamental challenges for an investor. Now that some of the latest signals from the private equity industry and the broader financial world appear potentially at odds, it may be a good time to investigate the nature of this enigma.

For months if not years, economists have been beating a loud drum about an imminent global downturn and a lack of readiness in government and the financial community. Most recently, the IMF’s David Lipton has described the world as “dangerously unprepared” in terms of crisis prevention, while the World Bank projected “darkening prospects” this year for developed and developing markets alike due to weaker trade and investment activity. 

Meanwhile, the flood to alternatives has continued apace. In its latest global survey of institutional investors, BlackRock noted as many as 60% of Asian respondents said the possibility of the cycle turning was influencing their plans, with about 40% saying they intended to increase exposure to private equity. Even at the risker ends of the spectrum, consistent talk of storm clouds has done little to dampen sentiment with global VC investment in 2018 said to eclipse even the record levels of the dot-com era.

The migration of capital to alternatives has been driven by a number of factors from a low interest rate environment and the idea that companies are staying private longer to downturn mitigation techniques that target relatively stable areas such as infrastructure. But the asset classes attracting investment in the face of gloomy economic warnings all benefit from a unifying quality: they are perceived to be cycle-proof to at least some degree due to their long timeframes.   

This perception is perpetuated by the various ways in which investors reconcile certainty in their theses with the humility required by a world of black swans. In the current climate a few basic schools of thought have crystallized. 

The most hesitant approach sees valuations as too high given the likelihood of a downturn. Economies are more fragile than they appear, and the best investments will reflect growth in segments that cater to hard times for family budgets, such as discount retail. The most aggressive approach recognizes that waiting to deploy is an attempt to call the cycle. Therefore, the best tactic is to simply invest in a more disciplined way and stick to your guns until your best bets emerge from the slump. 

Most industry participants, however, appear to expound a more measured ideology. This is the cautiously confident viewpoint that acknowledges the risks of a downturn but notes that volatility in public markets has maintained a relative viability for private assets. PE players in particular will cite contrarian investment strategies like special situations as sufficient downside protection under this doctrine. 

The status quo has persisted under these dogmas, perhaps especially in Asia since the region is broadly seen as a developing market opportunity set with longer timing horizons than global boom-bust cycles. But even in Asia’s more developed jurisdictions, investors are keen to flex the presumed cross-cycle advantages by scooping up companies when they’re cheap and turning them around when the economy turns.  

The problem here is not that investors are confident in the face of a downturn or express that confidence in a variety of ways. Rather it is the idea that these outlooks seem to ignore the pervasive nature of a global economic retraction and how even a long game can get permanently derailed by a temporary shock. 

Fundraising, for example, will become difficult in the event of a serious downturn, having a knock-on effect on a firm’s ability to address the market even after the macro situation improves. Likewise, existing investments will become harder to offload during the downturn. 

The alternative investment industry’s high morale on what is widely seen as an economic precipice suggests that many participants believe they can ride out a storm better than peers in other asset classes. This may indeed be true, but it is no excuse for a lack of frankness about the aspects of a downturn that no one can outmaneuver.

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• Topics
• GPs
• LPs
• Investments
• Asia