Sat, Jul 13, 2019 – 5:50 AM
IN every crisis, fortunes are lost. While the exact circumstances are specific to each situation, the primary reason is often too large a focus on illiquid investments, and not assessing the assets’ fragility during a crisis.
The first step in evaluating an investment is an analysis of the historical and the future expected return. This is followed by a risk assessment to arrive at an idea of the risk/reward profile. These two steps are standard, but many investors stop here.
Going a step further is a helpful exercise, by asking two more questions – how will this investment perform during a crisis, and most importantly, what is its liquidity profile (both now and during a crisis).
The vast majority of investments are fragile. They get damaged under stress, and may even permanently crack and not recover in a full-blown crisis. These crisis periods are a permanent feature of the economic cycle. Investors will experience at least two to three such events in their lifetime.
Fragile investments include equities, corporate bonds, currencies of countries that import investment capital, real estate, private equity (PE) and venture capital (VC). Gold also fits into this category, unless it’s an inflationary crisis.
There are a number of investments that are anti-fragile that actually gain from stress. A good example of this in everyday life is insurance, which would pay out should a crisis event occur. These assets are often ignored by investors, but play a key role in any portfolio whose target is to mitigate risk.
Liquidity is the most overlooked benefit of an investment. The most often quoted reason to invest in illiquid investments like private equity and venture capital is that returns are higher than equity markets.
Investors should realise that if you’re asked to give up liquidity for seven to 10 years or longer, you should be expecting a higher return.
Today’s markets are characterised by a deep interest in PE and VC investments. Investors are attracted to the potential of finding the next Google and Facebook. PE and VC are two specific fields where manager skill is absolutely critical.
The often stated “top-quartile manager” is not even enough reason to invest, as outperformance is very heavily skewed towards the top of the top quartile of managers.
Every VC investor should read the 2012 paper by the Kauffman Foundation titled We Have Met the Enemy … and He is Us, which can be found online. It gives an unbiased view of their personal experience in VC investing over many decades.
Their conclusion are that the best VC funds have indeed beaten returns of public equity markets, returning more than double the invested capital over the fund’s lifetime, after fees. There are however a number of less rosy eye-opening findings:
- VC’s heyday was in the 80s and 90s, when there was less competition. Analysing the aggregate of all VC funds with public data since 1981, the net return after fees is zero.
- The majority of VC funds fail to even return the original committed amount to investors, after fees.
- Top quartile is not good enough. A study analysed the bull market period of 1986-1999, and found that the top 29 VC funds invested US$21 billion and returned US$85 billion to investors.
The rest of the VC universe of over 500 funds invested US$160 billion, but only returned US$85 billion to investors. And this was during a tech bubble-fuelled bull market. Diversification in VC doesn’t work – you need to be invested in the top-tier funds, and only those.
In the majority of financial profile assessments we do, we find that investors are often more than 85 per cent in illiquid assets.
Liquidity is the most under-appreciated aspect in investors’ eyes, when in reality it affords you flexibility, especially when it’s needed the most – during a crisis.
Anyone who was forced to sell assets to raise cash during the 1997 Asian Crisis or in 2008 at deeply marked-down prices has experienced this first-hand.
Even if investors had the stomach to buy during such periods, only those in liquid positions were able to take advantage of these fire-sales.
Real estate investments are similarly both fragile and illiquid. In a crisis, tenants become more difficult to find, and at the very least the asking rentals drop.
What happens when an investor’s cash flow dries up and the rental doesn’t cover expenses? And of course no real estate investor fully pays up the property, so there are regular mortgage repayments to be made, increasing the investment’s fragility.
Leveraging a liquid portfolio effectively turns it into an illiquid investment. Being subject to a margin call from a large market drop is potentially even worse than having an illiquid portfolio, as investors are exposed to the risk of being forced to sell assets to meet loan repayments.
Add an anti-fragility and a liquidity analysis to all your investments. You’ll see the benefits during the next crisis.
- The writer is co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund-management services to endowments and family offices, and wealth-advisory services