#140 - Peter Kraus: Incentives vs Alpha

26:39And so it's actually a riskier investment. it. So I think the key in public investing is not, is there a right time? It goes back to, is it the right firm, individual team you're investing with? Does that team understand the timeframes of investing? Does that team understand and be motivated specifically to produce performance? If that team is focused on performance, because that's how they get compensated. And if they have a process that has a timeframe associated with this reasonable to believe that you can produce these returns, we'll go back to the multi-manager in a second, but not trade around earnings, not produce earnings in three months or six months or not produce alpha in that time period, but actually buy that stock that's going to triple over time or double over time because the earnings are going to double over time.

27:29Because you know that you would pay more for a company whose earnings triple over time than a company whose earnings go up 10 % a year. You just know that's the case. And that's a fundamental empirical fact. So you're investing with people who can find those companies and can identify those products. They're not going to get it right all the time. Undeniably, they won't. But if the portfolio on the whole can identify those stocks in three to four years' time, that portfolio would be worth more than the market benchmark to which it's measured. That to me is why you should be investing in active managers.

28:08You have to have that timeframe. You have to find that manager. Now you can argue, and I think this is the serious issue, is of all the active managers out there, there are many that do not fit that objective. The example that you gave, they have a lot of assets. They're in protection mode. Their fee incentives are not focused on performance. They have a small amount of assets, but their modus operandi is to grow assets because that's what management wants them to do. They are producing low beta product. So if you're an investor who wants low beta product, that makes sense to invest in that manager.

28:48But if you're an investor who wants return, you're looking to maximize your return, low beta product is not what you want. So I think that you have to go through the challenge of actually selecting managers who actually have as their objective to produce this return over three to four years and have a history of doing it. And that's hard to find because there are not that many managers that are structured to do that where you're willing to take that risk with them.

29:16Peter Kraus:I suppose another way to think about it from an investor's standpoint is start with an index as your default, and then you swap that for an active manager if it meets all the criteria that you described. Well said. In fact, I believe, I really do believe this. I mean, I believe it because Aperture is based on this theory, is that there aren't enough good managers in the world to actually invest 100 in active management there just aren't so therefore there needs to be a passive a significant passive portfolio every investor has now individuals don't have you know billions some do but don't have billions and billions of dollars so you know if you are investing your capital you reasonably can find active investors that can effectively absorb all of the capital that you want to invest in your managers.

30:14But if you're a pension plan with billions or hundreds of billions, it's not possible. You literally have to run a significant passive portfolio and find people who then produce active return that produce alpha over your whole portfolio. That is the way you should work. And that's why capacity constraints function. Because if you constrain my capacity and I produce a return and your objective is to not expose, let's just say, your large state pension plan, your$100 billion of capital to active management, which 30 years ago you did, but today you don't. If that's not your objective, then you can find people with capacity constraints and the capacity constraints don't bother you.

31:03So your formulation is exactly right.

31:07Peter Kraus:You made the distinction about multi-manager platforms. Would you talk about that a little bit? Look, multi-manager platforms are interesting constructs. They have, in the last 15 years, had a pretty good track record. I think that not all of them succeed. The larger ones that have survived have been very successful. Some of them in 2008 were close to collapse, and people forget that. And those organizations would tell you that'll never happen again. And I'm here to tell you that that's wrong. It will happen again. Maybe not to them, but it will happen again. And these are highly levered organizations, not the people, but the financial assets are highly levered.

31:54they are very good at firing managers that do not perform that is their key strength they hire lots of people i don't think they're particularly good hirers but i think they're very good at firing and they're very good at risk control because they run a lot of leverage but risk controls and leverage rely on historical precedent to control risk and when there are market shifts, structural changes that occur, that do occur, that will continue to occur until we're not on this earth, then those risk controls will not be able to control the risk. And that's when you have serious drawdowns. I think that where those managers fit is difficult to determine.

32:43Some of those managers are producing low double-digit returns. Most of them are producing high single digit returns. All right, well, equities produce high single digit returns over long periods of time. And high yield produces high single digit returns over long periods of time. You have liquidity, you pay less in fees, or you're actually getting something for your money. When interest rates were very low, credit was not a particularly attractive asset. And so some of the credit money leaked into the multi-asset space because multi-assets was producing six, seven, 8 % returns at one sharp ratios.

33:29And people said, wow, that's exciting because, you know, the 30 year was 2 % or 3%. Now the 30 year is 5%. And, you know, credit is producing high single digit returns or mid, I mean, this year, high yield is now producing much more than 2 % or 3%, but over time, as I said, high yield produces 8%, then really what's the purpose of that multi-manager asset unless it's producing 13? Now, if it's producing 13, yeah, that's interesting, but there are very few, if any, that do that consistently. So I think it's a very interesting construct. It's produced a lot of wealth for people in it. It's given investors good returns.

34:15The query is what return stream were they replacing when they went into that? And that's the part that moves around over time. And that's where I have a bit of a challenge trying to understand the applicability of the multi-asset manager.

34:31Peter Kraus:It could also be beneficial if it's highly diversifying, even if the return is comparable, right? It is diversifying. I mean, today, those managers are as much in credit as they are in equities. In fact, I think they're more in credit than they are in equities. They have macro exposure. So, you know, they're doing multiple things and they're also able to deliver innovation. So, you know, they change. They, again, I say they're very good at hiring people. And so they produce that diversification. So if you're getting a diversified, you know, return of 8%, great. But it isn't proven that when markets really crash, that that 8 % is sticky.

35:10Peter Kraus:Now, you mentioned the 2008 example. Yeah, it didn't stick. It most definitely did not stick. So private markets have become one of the most popular areas in investing. What do you feel investors misunderstand most about the risks and the opportunities in private assets? Well, I think people have largely undervalued the liquidity. I think large organizations and even individuals say to themselves, I don't need liquidity. But I think that when you need liquidity, when liquidity is really valuable, then you realize what you're giving up. Let's just take a simple example. Again, we'll take 08. So in 2008, obviously, the world blows up, hit all aspects.

35:59The only place that you have liquidity, the only place you have liquidity was equities. Couldn't even sell credit, public credit. So you would sell equities in order to get liquidity. and if you had all your money in private equity you couldn't sell so then you either had to come up with very distressed sales and private equity and in today's world you had to have private credit and you couldn't sell private credit in 2008 either if it existed which it didn't but if it did you couldn't sell it either so when you need liquidity if you're over allocated to private assets you can't get it there and what's the value of liquidity people are thinking well i need liquidity, I have some liability I have to pay off.

36:41Well, yeah, that's the stress case. But let's just say there's opportunity. Because in October of 08, if you bought the equity market in October of 08, or even in March of 09, the returns were dramatic. Much, much higher than the returns of your private equity vintage that you invested in that time period. So there was significant opportunity cost of having tied up your capital. So I'm not even talking about whether or not the return in the illiquid vehicle is actually as good as the public vehicle. That's a different conversation. I'm just talking about whether you're properly valuing the give up of liquidity that you're creating because you're being driven into private credit, because you're looking at returns in the past and returns in the past show over long periods of time in private equity, that it beats the active equity indices, not the active, the equity indices.

37:42And the problem with that analysis is that over 20 years, it's true, but over the last 10 years, it's not. You know, what does the future look like? It's hard to use the 20-year history as the future proxy, but now you're invested and you can't get your money out. So I think going forward, people who are looking to invest in private assets. And I don't see a reason why private assets aren't proper as part of your portfolio. They are. But I think the cost of liquidity is much greater than what individual and institutional investors have thought of at the time when they put the money in. In fact, in the private credit space, which is the latest rage and is maybe coming to its zenith.

38:28Investors said, well, look, Leopard Credit is giving me a 10 to 12 % return. So no vol, the same or better return that I get long-term in equities. What am I doing in equities? Just put all the money in private credit that earns between 10 and 12 % net of fee over time. If that were true over time, they would be right. But it isn't true over time. Because as I said to someone once, you know, there's a corporate finance construct where debt is more senior than equity. So a more senior instrument would obviously earn less. So at the end of the day, if the more senior instrument levered produces the better return than equity, who would put money in equities?

39:19Therefore, if no one puts money in equities, you can't have the senior credit because the senior credit becomes the equity. So therefore, the equity has to produce a bigger return. Well, if it produces a 15 % or 16 % return, then why do you want the private credit, which you think is giving you better returns in the equity? Yeah, it's obviously a circular argument, but it shows the point that when you have these outsized returns that don't make logical sense, they're generally not sustainable. And I think the private credit space is a space that can produce a return that's better than public credit because you can get paid for that illiquidity, but it's not more than 50 basis points.

40:04And investors were thinking it was hundreds of basis points. And that's what I everything drove many, many investors into the private credit space. Now, credit is a very complex area and credit indices are simple and credit investors investing against indices use lots and lots of different instruments that are widely different than the underlying index to produce returns. It's nowhere near as constrained or clean as environment as equities. so private credit could own structured assets which by the way i think are just fine but that's not in the credit index private credit could own distressed which is also just fine but it's not what you bought and these indices where the funds that are that are deploying your capital are usually quite diverse in terms of the risk that they're taking so you might actually have equity risk.

41:08In fact, I would suggest that if you looked at high yield or stressed equity hedge funds today, that you would find a significant amount of equity exposure. Not that they're buying public equities, but they bought debt securities that converted into equities and that their returns or they're attractive are being driven by equity returns, which is a lot more volatility. And so they too are combining credit and equity to produce an attractive return and are a little bit like the multi-strat. There's nothing wrong with that. I'm not saying there's anything wrong with that. There's just a place for it.

41:47And it's the amount of capital that you would allocate to it. And that's my real issue with the private space is that people have over-allocated to it because it's looked like a panacea to them.

41:57Peter Kraus:So for investors considering giving up liquidity to invest away from public markets into private markets, what hurdle do you think they should consider? Well, I think you said earlier, diversification matters. So I think that some degree of investing in private assets represents diversification and it's not subject to a return hurdle. It is subject to determining that it is diversifying, that it is something different than what you own. So we were talking about structured credit for a second. Public investors rarely invest in structured credits. There is a structured credit market in which they can invest, and there are structured credit managers.

42:42But if you look at the amount of capital that's in structured credit managers versus corporate credit managers, it's dwarfed by the corporate credit. So one place to invest in private is just diversification. Structured credit is diversifying from corporate credit. And so that's an interesting thing to do. Is investing in corporate private credit diversifying from what is generally a high yield credit? Yeah, to some extent, that's true. because in corporate structure, excuse me, corporate private credit, you generally get higher collateral or higher security interest in the company and generally better terms and conditions.

43:27But you get paid for that and you give up liquidity. So again, that's diversifying. So I think that I approach the world of privates from a diversification point of view more than a return perspective, because I don't think the returns in either credit, private credit, or in private equity are really that sustainable at today's scale. When I started in private credit, which private equity, I didn't start in private credit, but in private equity in 1989, you know, we bought assets from companies at significant discounts. There wasn't the same amount of capital that was competing to buy that asset.

44:16And if there wasn't the same amount of capital, you could buy that asset at a cheaper price. So that was alpha in and of itself. Today's world is much more competitive. There's much more capital. It's much harder to create alpha in the purchase. So you have to assume you're paying fair prices in all of these deals. So therefore, the alpha has to come from, you're a better operator. So there are private equity organizations that are very specialized, where the people in those organizations are expert in the industries in which they operate, and they can produce alpha from that. And that's an attractive place to invest with those teams, and have shown over time that they can produce that alpha, so long as they don't get too big, because then they have to start to move and they have to diversify away from the industries they know.

45:07And it gets harder and harder for them to produce the alpha that you invested in. But there is alpha in skill, in operating skill. And that's a place in which alpha still exists. But again, capacity constraint.

45:22Peter Kraus:Let me ask you a bigger picture question. So from the early 1980s through 2021, I'd say investors in general benefited from a powerful backdrop of declining interest rates and actually zero rates for a while. How much do you feel that environment masked weaknesses in investment strategies, business models, and even perceptions of manager skill? I would break the decline in interest rates a little bit into two pieces. Uh, interest rates declined from the late seventies, early eighties, uh, pretty much into the middle 2000s, 2003, 2004, maybe even 2005. That was a pretty much 30-year decline in rates.

46:05And it was over that time period that you saw dramatically attractive private equity returns, which to your point, in part, not in whole, but in part, were driven by the fact that you were persistently refinancing at cheaper and cheaper rates. And that created value in assets that were levered. You could say, but in real estate, state, did that actually occur? And it did occur, but it was punctuated by recessions, periods of time when rents fell or when demand for space declined, causing rents fall. Over that time period, if you were just applying constant rents to a declining interest rate environment, you would have declining cap rates and you would have value that was created solely from the declining interest rates.

46:57And that's the purest example of that occurring. But people did demonstrate skill in that time period because you would say, okay, but if I just owned a set of buildings that nobody ever did anything with and the rents were exactly the same over the 30 years and interest rates fell, I would earn a return from that. But nobody really can calculate what that is and they can't compare that return to the return actually earned. So you can't distinguish between what was skill and what was interest rates falling. And the same is somewhat true in private equity. But when you got to 2006, 2007, when interest rates started going up into the crisis and then down into 08, leaving those three years aside, we then had a period of what I would call almost depression-like interest rates or what people refer to as ZERP.

47:52And that was a different kind of problem. That wasn't declining rates. That was just plain ridiculously low rates. And any asset looked good. Any leverage looked good. Any attractive use of leverage, no matter whether you over levered it or not, produced an attractive return. Because the asset, the base asset you were leveraging had a return greater than zero because interest rates were negative. Real rates were negative. And so that period of negative wheel rates, you know, that created another kind of investment fog, if you will. Like, what were you really getting in returns? How much of that return was because negative interest rates existed?

48:30And how much of that was skill? They're both existed at all times. Both existed. But in reality, you looked at the bundled return and you said, oh, that bundled return is really what I want. You know, going back to my private credit example, when you're earning 10 to 12 percent because interest rates were lower than they should have been because OE created a global what would have been a depression. But for the aggressive stance of central banks in the world, you know, how much of that return comes out when that doesn't exist? Now we're in a world where there's no ZERP. There's no declining interest rates.

49:12probably we're in a world where there's rising rates or certainly flat rates for a long time and inflation is not going to zero if we get inflation to two percent we're going to be lucky two and a half i'd be happy and the fed can have a two percent target rate no problem but two and a half they'd be happy they wouldn't say that and interest rates are going to have to have a five handle on them in the long end and in the mid fours in the 10-year space and we're not going to to have a 10-year rate that's 2.5 % or a five-year rate that's 1.5%. That's gone. Not going to happen. So we have to think about capital structures, cost of financing in that light, and then skill was going to be more valuable because you're not going to have that tailwind that you referred to from interest rates.

50:02So I know that's a really long-winded answer and it's not exactly what you looking for but it is i think the fact that the last 40 years had kind of anomalous time periods of interest rates caused by a significant inflation in the early 70s late 60s in the united states that caused unusually high and inverted yield curve in the 80s that had to be retrained and restructured, and that took a long time for that to actually occur.

50:38Peter Kraus:And based on all of that, it seems that when you look forward, it's probably an environment where it's even more important to focus on being disciplined about the capacity, being very selective about the managers you choose and looking for alpha sources. I think that, Alex, because you don't have... It's like when you build a house, the ceiling and the wall come together. But it's not always a seamless line. And that's why you put molding up. So you don't have to worry about the seamless line. You have to spend all day trying to get the ceiling and the wall to actually connect. You put up the molding.

51:17Well, those declining interest rates were the molding. Effectively, they covered up things that didn't work exactly correctly, but still produced a decent return. And we don't have the molding. Now you're going to have to be good. And in order to be good, you need an amount of assets that doesn't tax you to the point of not being able to produce a return, where really all you can do with all those assets is just expose yourself to the beta. And, you know, you can see it in fees. If you look at these large organizations, you know, and the credit, let's just take the credit side. You know, they're raising large amounts of assets, like tens of billions of dollars of assets, 70, 80, 90,$100 billion of assets, but their fees are going down.

52:01Why are their fees going down? Because those assets are just beta. And the client knows it, and the company knows it, and the company's doing it because the marginal margin is attractive, and it produces more dollar returns, and their earnings grow. But where's the performance? There's no performance in those assets.

52:22Peter Kraus:It's just beta exposure. And then what happens to the clients when they're exposed to the beta is if they end up with too much beta, they're in an illiquid asset they can't trim very easily. And that's what you're seeing right now. That's what you're seeing today. Yeah, the two key takeaways, I'll summarize from what we just talked about. One is the environment of the past is probably unlike the environment of the future, largely with respect to a massive tailwind of falling or very low interest rates. versus what's more likely to transpire looking ahead. So that's number one. And basically what that means is you had this massive tailwind that masked some of the headwinds that investors naturally face, like fees and liquidity and luck versus scale, et cetera.

53:09Peter Kraus:So when that tailwind disappears and may potentially even become a headwind, the other headwinds become bigger factors to consider. So that's number one. Number two, it seems like we're just in the midst of this shifting environment. So effectively, what that means is you can't necessarily just look at past returns to assess what the future performance may be because the environment has drastically shifted. Yeah, I like to give this example for your listeners that have a little bit of financial history. So pre-2000 in the equity market, there was nothing that required investors or companies to share with every investor in the world some set of facts that they provided to an audience that they were speaking to.

53:56After reg empty, all the information was disseminated to everybody at the same time. And you got rid of all that selectivity. It's a little like your point about falling interest rates for 30 years. You got rid of the tailwind. And now people actually had to perform. And if you had$30 billion of assets or$20 billion of assets or $50 billion of assets in the equity space, or you had up$50 billion of assets in the credit space, performing became extremely difficult. You needed an edge. You needed to find that company was going to go up three times. Well, that company is going up three times. It's unlikely the$100 billion company.

54:34There are some today that have actually done that, but it's unlikely to be that. So it's going to be the smaller company where you can't own as much as many of them. You're not going to find as many of them. So therefore, you need to have fewer assets so you can expose yourself to the companies where you can get the capacity to actually invest in them. That's true in credit, and it's true in equities. Take structured credit, for example. Structured credit has 6 ,000 or 7 ,000 different securities you can invest in. You have to literally be able to understand the details, the structure, the cash flows, the defaults, the legal arguments in each one of those structures.

55:13there's a lot of opportunity for alpha but all of those structures you couldn't put a billion dollars in all six thousand of those structures maybe you could put 20 or 30 or 50 million in those structures so if you're running a 10 billion dollar structured credit fund or it's 20 billion dollar structured credit fund you just can't take advantage of those things you have to own the bigger asset exposures which means you own the beta you you lose the opportunity to own the alpha So as these headwinds appear, which happens when structures change, when markets change, when market structure is in flux, then you want to be able to control your capacity because that is the first line of defense against not getting anything other than market or below market returns.

56:03So you summarize for a second. I would summarize for a second and say there's two key issues here. One is the financial incentives that drive the investor. and two is the financial constraints around the capacity. And what you're trying to do is increase the probability that when you pick a manager, they can perform. Because this is just all a set of probabilities. And you're trying to increase that probability. You don't increase that probability by squeezing managers on fee. You actually reduce the probability. You do increase the probability when you choose a manager whose financial incentives are consistent with yours.

56:40and you do increase the probability when those financial incentives and the manager constrains their capacity. Those are two big key issues that increase the probability that you will get a return.

56:52Peter Kraus:If we were having this conversation, let's say 10 years from now, what do you think will have changed most dramatically about the investment industry? I think that more and more of the industry will pay attention to these principles we're talking about. Because if I look back 30 years ago and look at the industry today, I would say that more and more people are paying attention to these issues. But it will never be pure. There is always going to be the agency risk that creates the branded companies that collect a lot of money. There's always going to be a business structure that rewards lower fees and more assets.

57:33And so this isn't going to be monolithic. This is going to be a diversified, fragmented world where you're going to see more and more managers behave like I'm talking about, but there's still going to be fewer assets than the assets in the other side of the world, because by definition, they have to be. It can never be as large or larger, because if they are, they're going to defeat the purpose of what they're trying to actually accomplish.

58:03Peter Kraus:Peter, this has been a fun conversation. Do you have any final thoughts for our audience? I would say three things. I think, number one, I continue to believe that investing is a very challenging activity. And I think choosing investors is a very challenging activity. Your job as someone choosing investors is to find people that have this consistency of motivation with your objectives? So are the financial incentives actually focused on the objectives that you want the investor to actually satisfy? And secondly, is the investor aware of and willing to control the constraints, the amount of capital that they actually manage?

58:47Those two things are critical and they're in your control. And the third thing that's in your control is to defeat the agency risk. The agency risk will lead you to a point of mediocre returns. It's really hard to constantly satisfy the agency risk and to end up with returns that do substantially better than the market.

59:09Peter Kraus:Very useful advice. Appreciate you joining us today, Peter. Thank you. Thanks, Alex.

59:22Peter Kraus:Important information. This podcast is provided for informational purposes only. It should not be considered legal, tax, investment, or business advice. It is not a solicitation, recommendation, or endorsement. All opinions expressed by participants are their own and do not necessarily reflect the views of the Evoke Advisors Division of MAI Capital Management, LLC, or Evoke, its affiliates, or any companies mentioned. Information shared has not been independently verified by MAI or its affiliates. MAI Capital Management LLC, or MAI, is registered with the U.S. Securities and Exchange Commission, SEC, which does not imply any particular level of skill or training.

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