Global Liquidity

Part One starts below. This is Part Two.

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Ever wonder what a guy thinks about when riding into a headwind for hours on end? Well, sometimes he thinks about global liquidity. My head is a strange place to be at times.

Where does money come from? Or most interestingly, what causes money to disappear rapidly?

If you have read a good book on the major drivers of global liquidity then please send me the details. I’m very interested in this topic.

When I started my finance career in the early 90s many of the major US lenders decided to close their European loan books – immediately, pretty much regardless of cost. There was a legacy of poor loan decisions, many teams were dismantled and the assets sold off. The fact that global markets are flush with easy money, on soft terms, has me wondering about the impact and timing of the next credit downswing.

Starting my career in London, the debt markets were very poor and we could barely make any deals work (not that I really knew how to make anything work back then). Thankfully, we didn’t have a lot of duds in the existing portfolio. However, the duds that we did have were under a lot of pressure. We lost quite a bit of additional capital supporting businesses and management teams, which ultimately failed. Collectively, following our money was a poor investment decision. There were a couple of exceptions but these only appeared once we had realised how much capital we were throwing away (and adjusted our refinancing pricing radically).

From the top down, we behaved like we were investing 100% of our own capital – rare within much of the financial services industry. This “emotional” attachment to the capital can work against you at times but, overall, is a big plus in my view. We learned from our mistakes and spread that information internationally throughout our group.

I was the absolute lowest guy on the totem pole and my team was highly conservative – at least half of us rank alongside the most conservative investors that I’ve ever known. Eventually, we started to get a few deals away that looked attractive to us. Others in the field were far more aggressive and we thought them to be a bit nuts. With the tail wind of a bull market and falling interest rates, we all made money.

In VC the rules of the game are stacked in the house’s favour with the partners taking 20% of the upside and the investors bearing the downside risk. There is isolation between funds and illiquidity for investors, so a couple of poor years don’t bring the whole thing crashing down. With hedge funds, the partners can make a lot more money sooner but with VC, the best firms are able to lock-in a stable long term income stream on top of the carried interest over future investment profits.

Anyhow, where is this going?

I’m quite fascinated by the credit cycle within various classes of assets as well as the drivers of global and regional liquidity. Having worked & lived many different places, this seems to be a key driver in short- and medium-term asset price fluctuations.

When there is a lot of liquidity around, times are very good for nimble financial investors. In the UK, we haven’t had a really bad credit squeeze since the early 90s. When I see lackluster consumption and increased government expenditure set against a background of increasing taxes and high personal leverage, I wonder it the cycle is set to swing against us. If that happens then it will be a good time to be liquid and/or have access to a well-funded investment vehicle.

I wonder what impact it has when a group of smart people think similarly.

I look around at certain deals that are getting funded and sense that actual returns are bound to disappoint. Once a bull market slows (or stops), leveraged long vehicles get hammered (in any asset class).

Within quality deals, I sense that actual returns could be 5-8% per annum lower than projected but outstanding when compared to how the asset class is going to perform over the next 5-8 years. Current expectations being unreasonably influenced by recent history.

I speak with investors about property sector return expectations and find many of them far out of line with long term historical real return performance. As an example, many institutions are targeting 15-20% per annum rates of real return from asset backed investments. You can play the game, or you can have a word with the smart people that are backing you and ask if they really believe the managers that show them those numbers. I’ve always felt that it is better to be open and conservative than to simply cook the model to show the desired result. Of course, that doesn’t exactly help when you are fundraising and competing against superior marketing horsepower.

Pushing for unrealistic return expectations has the impact of forcing good, conservative management teams to bump projections to the limit in order to get quality, lower risk deals approved. It’s tempting to think that you’ll end up with higher returns from higher expectations but I’m not so sure. We might simply be increasing the standard deviation.

Anyhow, I’m kicking all of this around because my current vehicle is proving a bit tough to invest at present – greed is dominating fear in the Scottish property sector and we’ve been out-bid on a number of deals in 2006. Having lived through this before, I think that is a good thing because the deals that we have locked up are going to be stars and (due to compounding effects) a good opening year provides an equity return platform that benefits the entire life of the vehicle. On the flip side, if you screw up your early investing then you are likely stuff for the entire vehicle life.

We are compensated on actual deals done (rather than capital committed), so our investors pay no penalty for the fact that we have plenty of additional capacity at present. It does create an interesting conflict for us in that we have a clear financial incentive to do any reasonable deal (via our management fee). However, we also have our personal capital at risk, the capital of most of our good friends as well as the capital of the man that got me started in finance. Personally, I have no interest in being associated with a mediocre investment vehicle. I’d much rather be small and highly profitable than large and average.

So that’s what I’ve been mulling over for much of April. It was interesting to be able to think at a location that is distant from the noise and influence of the market.