A lemming is a creature that instinctively follows its fellow creatures. Unfortunately, lemmings have been known to follow their fellow lemmings off a cliff, falling to their deaths. Rational behavior is not programmed into their DNA, at least when it comes to overriding bad decisions that can lead to their demise.
Unfortunately, we see this behavior across the investing landscape. Rational behavior would instruct us to buy for a low price and then later to sell for a higher price. In reality, emotions mostly drive investors. Investors buy after they see so many others buying, often when prices are driven higher. And they sell when they observe so many others selling, often when there is bad economic news and prices are driven lower. Buying high and selling low is their reality, often driven by strong emotions and the need to follow others in justifying their decisions. Professional investors attribute this very human behavior to emotionally driven decision making – similar to lemmings.
The majority of private investing is no different. Rational behavior instructs fund managers we hire to buy low and later, to sell high. That would generally mean a fund manager buying companies reasonably by paying 7 times company cash flows, working to create value in those companies over a period of years, and then exiting their investments for higher outcomes. In reality, we observe many managers buying high, then hoping to create value so that they can sell higher, but as a result the risk of actually exiting at a loss emerges, especially on highly leveraged investments.
So why does this behavior occur in private investing? The answer starts with the fact that too many investors behave like lemmings. When a reputable pension fund like CalPers announces (as they did again in 2018) that they are doubling down on private investments with the goal of lifting their otherwise low single digit portfolio returns, most of the investment community notices and acts similarly. And when one examines the incentives of most institutions’ investment staff, who are not likely to be aligned with their beneficiaries, one notices perverse decision-making. The primary goal of many pension investors is to enhance their resumes and not get fired in the process. They begin to gain a false sense of security by relying on the largest brand name managers who do a fantastic job of marketing their branded funds to grow their ever-increasing billions in AUMs (2019 was a record year for fund raising and available cash on hand to invest).
In turn, these large funds grow larger, as do their largest competitors. These funds struggle to find inefficient opportunities in which to deploy their billions. They compete for almost every deal they fund. And they drive the purchase price multiples much too high, into the 11-13 times cash flows range and beyond. Yet these mega funds have to still deliver some sort of return that justifies the fees and illiquidity for which their investors sign up.
Value creation is difficult to implement in large companies over relatively short periods. And all too often, mega fund managers turn to the excessive use of leverage to enhance otherwise unworthy returns. In 2018 alone, roughly 15% of leveraged buy-outs used 7 times cash flows in leverage to artificially enhance their potential outcomes. This behavior may be fine in a low interest rate, non-recessionary environment, but downturns are unpredictable and interest rates do rise, making the risk of a bust very real. Even in normal economic times, Toys-R-Us type bankruptcies should be a wake up call to investors who commit to funds employing such risky behavior. Despite this observable fact pattern, many investors continue to send their billions to the mega funds, even during the late stages of our current economic cycle.
There is a better way to invest, even in this environment. Just say no to becoming a lemming investor. Don’t accept the unnecessary risk. Don’t follow the crowd off a cliff. Of the more than 8000 private managers, there are a fair number who invest appropriately and mitigate their risk. As discussed in my prior articles, do the work, ask the questions, seek alignment, and do your best to avoid truly unnecessary risk.
Column by Alex Gregory