It is an old kitchen maxim that “a dull knife is more dangerous than a sharp knife.” It’s not so paradoxical for anyone who has done any cooking. Dull knives have quite literally lost their edge. They behave unpredictably, a risk compounded by the additional force the user typically applies to get them to work. They shoot to the left or right when they should descend straight down, catch in the middle of a long cut, and seem more prone to hop off the board entirely.

I recently had my kitchen knives sharpened and was shocked by their newfound efficacy. Knowing the instrument was sharp, I also noticed how much more care I took. Another risk of dull knives is the carelessness with which we wield them.

Knives are a form of leverage, a mechanical advantage that creates more output force than input force. Output force is more likely to turn back on you when using a dull knife.

In How to Lose Money, I wrote about Bob Citron’s blow-up of the Orange County Investment Pool, but countless sophisticated investors have been wounded by instruments they thought they understood. D.E. Shaw invokes the woodshop instructor:

"Leverage and power tools share three fundamental properties: they can be extremely helpful, they can allow for far greater precision, and they can be really dangerous, even in the hands of experts. We would wager that some of us who took a woodshop or metalshop class in high school had instructors—however masterful a carpenter or machinist—who were missing at least one finger due to a moment of inattention while operating a table saw."

Financial markets are littered with dull knives.

Zero-day options, levered ETFs, and betting markets that hide derivatives principles behind real-world binary outcomes are dull knives. While they may be transparent regarding the amount of leverage employed, the terms, reliability, and structure of the leverage are obscured.

Information asymmetry is great for the sellers of these products and bad for the users. It preys on a jackpot mentality that has spread rapidly through society since 2020. As wealth from crypto, SPACs, and gamified options trading seemed to be doled out randomly, investors saw a game they thought they should be playing. There is a simple bias at play: the fact that people can win far more than they lose gives an intuitive but entirely inaccurate view of risk and reward.

Scimitar Capital wrote an excellent explainer of “the Jackpot Paradox” a few months ago. Assume a coin flip game where one can double their net worth on heads, but lose 60% on tails. This creates an expected 20% net worth gain per flip. Stopping there, you should flip the coin infinitely.

But this expected value reflects the arithmetically average outcome, which includes the exceedingly rare consecutive heads outcomes that create extraordinary wealth. In fact, the expected (average) value is heavily skewed toward these outcomes. It’s the average of ALL possible outcomes.

When you use a geometric mean that reduces the statistical weight of jackpot outcomes, the expected value of the game turns negative; it compounds negatively over time.

Per Scimitar:

“The discrepancy between arithmetic and geometric means forms what I call the Jackpot Paradox. Physicists call it the ergodicity problem and traders call it volatility drag. You can’t always eat the expected value when it’s squirreled away in rare jackpots. Risk too much hunting jackpots and the volatility will turn positive expected value into a straight line to zero. In the world of compounded returns, the dose makes the poison.”

It’s hard to tell if a knife is sharp just by looking at it — most people rationally assume every knife is sharp. Most chefs will tell you the vast majority of knives are, in fact, quite dull. Investors face a similar paradox.

Financial markets do offer some sharp knives.

The zero-sum nature of markets leads people to believe that any time leverage is offered, the loser is more likely to be the borrower than the lender. However, terms and time horizons are not static across participants, and the entire function of finance is to move money through time.

Borrowers need future dollars today, while savers and investors require today’s dollars sometime in the future. Markets match these parties across price and terms. Occasionally, those factors align in favor of the borrower.

Home Mortgages

The most obvious example is the American home mortgage, which offers 30-year, fixed-rate debt with no prepayment penalty. The structure of this leverage is extremely borrower-friendly, but the terms also benefit lenders because it creates both a steady stream of origination and the homogeneous structure supports a robust secondary market for the assets.

The Equity of Investment-type Companies

There is an argument that balance sheet companies, or in Whitman’s words “investment-type companies,” such as REITs, BDCs and other specialty finance firms, are sharp knives that investors can access. The public equity of these firms allows investors to participate in the leverage extended to the entity, often term debt with lower rates, to make investments that yield above the companies’ cost of debt financing.

GP Participation in Private Equity and Credit

Equity participation in General Partnership stakes, such as the large public alternative managers Apollo, Blackstone, and KKR, is a sharp knife. These firms effectively get paid a steady stream of fees to originate call options on their underlying portfolios, with equity investors benefitting from the realized carry of those investments.

On financial innovation…

Finance gets a bad rap. The phrase “financial engineering” often carries a pejorative connotation. At the heart of most speculative blow-ups is some form of misunderstood or misapplied leverage.

At the same time, our quest for non-inflationary growth demands debt. Households don’t merely want to exchange goods; they also try to allocate their financial capital in ways that build long-term wealth, often involving some form of leverage. Hyman Minsky scholar Martijn Konings writes,

Economic interaction is ­shaped not primarily by the wish to exchange our surplus commodities but by the drive of economic units to secure their ­future by making the right investments. Financing such investments requires economic units to borrow from ­ others, and in this way households weave an intricate web of debt relations.

A huge whitespace exists for creating financial products that help investors make markets their servants, not their masters.

In 2012, Yale economist Robert Shiller wrote “Finance and the Good Society,” arguing that finance serves as a "social technology" that can advance human welfare by efficiently allocating resources and spreading risks across society.

“The key to achieving our goals and enhancing human values is to maintain and continually improve a democratic financial system that takes account of the diversity of human motives and drives. We need a system that allows people to make complex and incentivizing deals to further their goals, and one that allows an outlet for our aggressions and lust for power. It must be a system that redirects the inevitable human conflicts into a manageable arena, an arena that is both peaceful and constructive.”

I used to work in timber markets and became fascinated with how environmental services markets formed, using regulation as a primer for liquidity in hard-to-price social and environmental outcomes like clean water or carbon capture. Last year, I explored an idea wherein homeowners could swap a portion of their home equity, and the “buyer” would take on the liability of their property taxes. The elderly could use this to manage their expenses on a fixed income. Conversely, younger home owners could apply the savings to build equity in their home faster than they would otherwise — property taxes can represent up to 20% of a mortgage payment early in the life of a mortgage.

We are far from the limit of what the social technology of finance can do, but we are even further from its spirit. Minsky called the inevitability of debt in social relations the “Wall Street paradigm,” a way of thinking that has infiltrated society far broader than when it was coined. Meanwhile, most “Wall Street” innovation has focused on distributing dull knives to amateur chefs.

A prevailing narrative has evolved around private credit's meteoric rise from roughly $1 trillion in 2020 to nearly $2.5 trillion of assets today. It is easy to suggest that hapless allocators were lured with high yields that didn’t come with the accompanying volatility. This explanation, while convenient, misses the fundamental driver: Equity markets have systematically failed to provide accessible capital to the broad swath of American enterprise, forcing a mass exodus toward private debt markets.

I’ve written my fair share about private credit and its expansion into insurance with more than a degree of skepticism. That private credit represents some sort of growing risk has installed itself as, paradoxically, a broadly held “contrarian” opinion.

Markets of all stripes climb walls of worry, but the expansion of private credit has been particularly vexing. I’ve heard a variety of theses that private lending is the next “Big Short.” Those theories presuppose that asset growth is downstream from buyside allocation decisions and not reflective of demand from the users of capital, i.e. companies themselves.

Just as investors seek out the best risk-return tradeoffs, so too do companies seek to minimize their cost of capital. Instead of asking why investors are so eager to lend, it is just important to try to understand why companies are so eager to borrow at ostensibly high rates.

Canary in the coworking mine

When WeWork's IPO collapsed in spectacular fashion, few recognized it as a harbinger of a fundamental shift in corporate America's financing landscape. Once valued at $49 billion, Neumann’s Folly found itself scrambling for survival after investors rejected its business model and excessive debt load. By March 2023, WeWork was negotiating a $1.5 billion debt restructuring with SoftBank – explicitly stating that traditional equity financing was not viable due to market conditions. What appeared to be an isolated corporate disaster was actually the first domino in a historic capital migration that would reshape how companies fund growth.

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Somewhere you made a choice. All followed to this.

- Anton Chigurh, No Country for Old Men

It could have been when the Fed bought high-yield bonds in 2020 or quantitative easing following the Global Financial Crisis. It may be as far back as the 1999 Gramm-Leach-Bliley Act or the Telecommunications Act of 1996. It could have been developments beyond our control, like China’s ascension to the WTO in 2002 or as far back as the Berlin Wall coming down. At each moment, we took a turn further toward the way of organizing the world most of us are now accustomed to. It was, and is, a historical aberration. A world where the free flow of capital meant that peace among superpowers was maintained by the tensions of highly integrated trade has never existed at the scale achieved over the last 40 years.

Corporations, increasingly driven by shareholder primacy, redirected investment from domestic production toward global supply chains and financial engineering. This architecture generated substantial aggregate wealth but distributed it with growing inequality. The availability of ever-cheaper imported goods alongside the distribution of high-speed broadband and mobile telephony offset middle-class wage stagnation. These forces, once celebrated as engines of prosperity, now reveal themselves as architects of the very instability they were meant to prevent.

When President Trump unveiled his hastily assembled posterboard with effectively arbitrary tariffs, far more severe than anyone (perhaps even their author) expected, that way of organizing political and economic life ended. In the following week of tumult, when the harshest version of the policy was eventually downgraded or delayed, many intelligent writers and analysts opined. They have crunched the numbers, been apoplectic about the recklessness, and applied all manner of game theory to attempt to make the unintelligible intelligible. I have no interest in rehashing those exercises here. Instead, I wish to explore the collective delusions about our economy and its future revealed by this episode.

The central question is not whether Trump's tariffs are economically optimal—they almost certainly are not—but rather what their implementation reveals about the fragility of our economic consensus.

The first delusion is that Trump’s extreme trade policy differs from any other exogenous shock to the system that could have arisen in such a highly levered and geopolitically tense environment. We would be in nearly the same place today had China invaded Taiwan, or if the EU had become more fractured, or if Russia made another military overture.

Protectionism was growing, and any number of developments would have accelerated its more extreme forms. It may feel different since the spark was an admittedly ham-fisted policy unveiling from the leader of the Free World. Still, practically speaking, it was always going to be something that eventually cracked the reign of globalization.

The Cargo cult mentality that technocratic competence could overcome growing unrest hid a surfacing crisis of faith. Brexit, the growing popularity of far-right politicians in Europe, and of course, the heavily lopsided election in the U.S. were all directly counter to the perceived universal acceptance of liberalism and free trade. These political shifts were only tangentially and often wholly unrelated to trade.

In fact, the second such delusion is in narrowly defining trade as the central issue. Trade has been a necessary, but not sufficient, condition for the divide in perception between growing economies and stagnating social mobility. In 2023, the FIRE sectors (Finance, Insurance & Real Estate) contributed more than 20% of value-added GDP, while professional services added another 13%. This has famously corresponded with a decline in manufacturing, which has fallen from 20% of GDP in 1980 to less than 10% today. While much of the public messaging around trade has focused on restoring American manufacturing, shrinking the FIRE sectors, and “rebalancing” corporations are the more immediate and salient impacts.

As Russell Napier points out, the world fell into a monetary and trade system imposed from abroad,

“When interest rates appear to be permanently depressed relative to growth rates, asset valuations rise, leverage increases, and investors are incentivized to pursue gain through rising asset prices rather than through investment in new productive capacity. The decoupling of growth and interest rates was driven by the People’s Bank of China’s (PBOC) appearance as a non-price-sensitive buyer of U.S. Treasury securities, and indirectly by the role China’s excessive fixed-asset investment played in reducing global inflation and hence interest rates.”

In the U.S., the most successful companies have pursued high-value-added services or business models that extract rents from intellectual property, moving actual production to progressively cheaper geographies. In the blackboard understanding of free trade, “the winners win, more than the losers lose.” That understanding is based on the belief that the availability of cheap goods is more than ample compensation for the loss of social mobility or security through traditional employment. For most economists, cheaper goods and higher consumption are values in themselves.

The expansion in the U.S. has been driven by hyper-profitable firms that require relatively fewer employees, driving up productivity but at the cost of economic dynamism that spreads those gains more broadly. The economies of Ghana and Germany wrestle with unique issues of their own, but they represent the two sides of globalized trade. Ghana is a Ricardian dream of specialization and enjoys lower unemployment and a higher GDP per capita growth rate than Germany's. Germany’s economy is more diverse but sub-optimal in the traditional understanding. Ghana is unlikely to ever Westernize or become a functioning social democracy. Nor will Germany ever be able to fully capitalize on the innovations its diverse, complementary industries may generate. The populations of both find themselves in perpetual malaise.

The U.S. economic schema has become an amalgam of the two. With a concentrated economy primarily focused on finance, services, and software, the US has experienced the same free trade “wins” of low unemployment and GDP growth. Like Germany, it has benefited from access to low-cost goods manufactured elsewhere. And, like Germany, its politics have moved further to the right, rejecting little by little the policies to which elites credit its abundance.

The wonks consider these populations rubes, simpletons taken with populist rhetoric. A more rational explanation is that free trade's “winning winners" simply got too concentrated in a few industries, specifically a few geographies. Eventually, the larger population no longer felt that the benefits of cheap goods were adequate compensation for their declining employment prospects and growing economic precarity. The same statistical aggregates that economists celebrate obscure experiences of citizens increasingly alienated from globalization's promised benefits.

The fundamental conflict the current trade disruption exposes is between efficiency and resilience. We prioritized efficiency through global specialization for decades, creating complex, interdependent systems that maximized short-term economic gains while introducing systemic vulnerabilities. The pendulum is now swinging toward resilience. The messier, costlier arrangement in the short term but potentially more sustainable in an era of mounting geopolitical tensions and social unrest. This rebalancing will be painful and disruptive, challenging the primacy of shareholders and forcing a reconsideration of how economic value is created and distributed.

Tariffs, as currently conceived, aren't a complete solution to our economic imbalances, but they do directly challenge the conditions that have allowed specific industries to flourish disproportionately. While I don’t expect any of the promised gains for Main Street anytime soon, the specter of upended trade will change corporate investment patterns. Just as COVID inspired a re-jiggering of supply chains that continued long after the immediate impacts of the pandemic subsided.

Many have suggested that uncertainty will freeze investment capital required for corporate rebalancing into productive asset development. Perhaps, but policy volatility tends to be directional, so while the exact breakdown of tariffs and the carve-outs remains to be seen, corporations have undoubtedly gotten the message that we have taken a decisive turn away from the unfettered march of globalization. Just as the seemingly disparate policies of the 1990s and early 2000s created a progressively more integrated world, tomorrow’s policies will walk us back from it.

The reconfiguration of global trade will inevitably produce outcomes that defy our current projections. While protectionist rhetoric often evokes nostalgia for mid-century manufacturing dominance, replicating developing nations' manufacturing capabilities would be economically unviable and strategically misguided. The goal is not to turn back the clock but to catalyze new forms of productive investment better aligned with America's existing capabilities and future needs. Economic disruption has historically been the crucible in which innovative business models and technologies emerge.

We may see the emergence of advanced manufacturing ecosystems centered around critical technologies such as semiconductors, biotechnology, clean energy infrastructure, and defense-adjacent industries. We might witness investment in currently undervalued domains such as infrastructure modernization, housing development, and regional economic diversification. Or we may not, but it was abundantly clear that the existing paradigm would never deliver them.

Perhaps the most profound irony of our economic moment is that the dogmatic adherence to free trade principles has sown the seeds of its own rejection. By elevating economic efficiency above all other considerations, the architects of globalization dismissed legitimate concerns about social cohesion, community stability, and national resilience as parochial or misguided.

This intellectual hubris bred a dangerous disconnect between policy elites and the citizens who experienced globalization's dislocations firsthand. Over time, this disconnect fostered a deep skepticism toward expert opinion and institutional authority, creating fertile ground for political movements that promised to upend the system experts insisted was optimal.

Economic systems ultimately require social and political legitimacy to endure. Western liberal economies benefiting from or even relying upon the innovations, labor, or resources of authoritarian or communist states is an obvious incoherence. Trump's tariffs represent not an aberration but a predictable culmination of contradictions built into the globalized economic framework.

For decades, the neoliberal order rested on tenuous contradictions: democratic legitimacy alongside increasingly concentrated economic gains, national sovereignty alongside borderless capital flows, and domestic stability alongside perpetual creative destruction. It operated on borrowed time, sustaining itself through elite consensus, institutional inertia, and the absence of viable alternatives. This system maintained credibility only as long as its broader benefits remained visible to the average citizen.

The panic, the bargaining, the anger—it was always going to be this way. What we witness now is not a temporary deviation from an optimal economic arrangement but rather the system's internal logic reaching its natural conclusion. Despite a decades long effort to silo them, markets ultimately require public consent to function.

Summary

This week, American Affairs published an extended version of my Ouroboros piece. I support American Affairs’ mission to be “a forum for people who believe that the conventional partisan platforms are no longer relevant to the most pressing challenges facing our country.”

I’d encourage anyone interested in long-form commentary on industrial policy, cultural evolution, and political theory in America to consider subscribing. The quarterly print version is a high-quality journal worth saving or, ideally, passing along to intellectually curious friends.

The below is an abstract; paying subscribers can download a PDF of the entire essay below the paywall.

Subscribe to American Affairs

Last week Amit Seru, a professor of finance at the Standford Graduate School of Business, published an op-ed in the Financial Times urging private equity to be cautious in pushing for “retail” adoption of the asset class. In doing so, Professor Seru seemed to tacitly acknowledge the shortcomings of the strategy. It’s risky, illiquid, expensive, and, most importantly, free from onerous regulations like the Employment Retirement Income Security Act (ERISA). Seru writes,

Regulations such as the Employee Retirement Income Security Act and securities laws exist to shield retail investors from illiquidity and leverage risks. Private equity funds are currently not subject to Erisa unless retirement plan investments account for more than 25 per cent of total assets. More retail money could see funds cross this threshold.

Seru seems unaware that the proverbial fox has already found a side door into the henhouse via the annuity channel. In July of last year, I wrote about Apollo’s unique approach to insurance and how their merger with Athene represented a new era in the insurance market. Private credit grew rapidly even before the demand from increased annuity flows. However, the combination of stretched equity valuations, poor fixed-income performance, and higher yields made the perceived safety of annuities appealing.

My argument then, as now, is that supplanting traditional savings with an insurance product fed by credit created to meet retirees' needs upends a fundamental economic identity. In both Keynesian and Classical economic models, investment equals savings, and savings are forgone consumption. There is nothing wrong with choosing an annuity as a savings vehicle, provided the insurer matches liabilities with assets already in the capital markets.

Alternative manager-led annuities differ because they use the insurance balance sheet to originate de novo debt via the private credit market. The more annuity contracts, the more private credit assets must be originated. In doing so, asset-backed debt becomes a deep pool of potential credit origination, including consumer finance pools. In a dystopian end-state, savers might enter annuity contracts funded by their own levered consumption.

Even short of this, debt creation no longer follows equity in the traditional sense of allocating capital; rather, debt creation becomes a goal in itself. In the forthcoming Spring issue of American Affairs, I chart the longer history of retirement in America and how the credit-led annuity market is really the convergence of three secular trends: The end of defined benefit pension plans, the dominance of passive investing, and the ascendance of private equity.

It is telling that Seru specifically touched on ERISA in his FT piece. ERISA arose after several high-profile pension failures and began the march towards defined contribution retirement offerings. In trying to protect pensioners, ERISA ultimately created an entirely new market of financial product consumers.

Whereas defined benefit pensions had assumed investment risk, defined contribution plans shift that risk to employees and, in doing so, create the perception that financial markets are savings vehicles. Investing is, of course, a form of savings. Still, for much of financial market history, capital allocation was carried out by active investment managers, bank loan officers, and others who carried the burden of identifying productive enterprises and avoiding value-destroying ones.

ERISA’s establishment of a fiduciary duty focused heavily on minimizing investment management fees, creating a regulatory moat for passive investment vehicles.

A debate rages about the influence of passive investing on price discovery, but what is not debatable is that passive investing significantly impacted the margins of the asset management business and created a handful of dominant firms whose assets are overwhelmingly managed in passive strategies.

Innovation in asset management took the form of “alternative investments,” of which private equity was the primary expression. The fallout of the Global Financial Crisis simultaneously made private equity's optically low volatility look even more attractive, while the monetary response of low rates boosted the value of their assets. At the same time, banking reforms created an industry of non-bank lenders that specialized in lending into the rapidly growing private equity market.

Multiple analyses show that nearly half of the private equity returns come from multiple expansion, not a fundamental business improvement. When multiples stopped rising, private equity leveraged company cash flows for dividend recapitalizations, adding debt to generate returns.

Private equity is now struggling to return capital to their LPs (mostly pensions and endowments), constraining new fundraising. When debt markets became less amenable to dividend recaps, private equity began putting the assets on the balance sheet in hock, structuring asset-backed paper that could be distributed to different pools of capital. Perhaps annuitants can squeeze a few more drops from the dirty sponge.

In fairness, annuities are still a tiny part of the global market pie. If rates stay sustainably higher, annuities may maintain their popularity, but if a prolonged recession or exogenous shock were to reset asset prices, savers might again be willing to assume more traditional risks. Right now, outside of acutely speculative markets, there seems to be a general unwillingness to take equity risk.

I won’t claim to know where all of this is heading. There is an impulse driven by GFC muscle-memory to predict some sort of fallout, or “Minsky Moment,” but the reality is that risk is far more diffuse than either the GFC or the Savings & Loan Crisis. Should the primacy of debt in financial markets continue, I think a more likely path is that returns across the capital stack gradually degrade as malinvestment proliferates.

With long-run domestic GDP growth of 3%, everyone seems to be underwriting 6-8% nominal investment returns. What’s unclear is where all these pockets of high-value-added economic activity are taking place. Could the marginal productivity of this new debt really be greater than one? Or are we just slicing, dicing, and structuring secularly shrinking real returns? Running in place may be sufficient for those on the cusp of retirement, but for everyone else… devils take the hindmost.

Paying subscribers can download a full PDF of the American Affairs essay below the paywall.

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In a year where many investors found themselves on the wrong side of reason, it is worth reckoning with how to pursue investing in light of the human ego and the desire for order amidst entropy.

In my mid-twenties, I took a hiatus from asset management to open a butcher shop with two partners. I would be the “business guy,” which meant keeping the financial plates spinning and finding ways to make payroll, while my other two partners were trained whole-animal butchers from New York. As a whole-animal butchery, primal cuts would be delivered directly from farms. We would then break them into sub-primals for the case and produce various value-added products like sausage, deli meats, and charcuterie.

We considered ourselves craftsmen—artisans re-establishing a lost tradition. A particular sausage might be “Sage and Toasted Mustard Seed,” which required someone standing over a gas range to toast mustard seeds. We would get creative with less popular cuts. For example, we used beef tongue to make pastrami to sell cuts like beef tongue to unadventurous suburban customers. We won a national award for the beef tongue pastrami, one for a Tasso Ham, and another for a Pâté de Campagne.

None of this was particularly profitable, and after four years of what felt like a constant fistfight to stay above water, my partners and I eventually decided to move on to careers that could support a family and didn’t require year-round stress over costly, highly perishable inventory. We had committed and sacrificed so much to be great, dogmatically committed to our standards, and respected as much by our contemporaries as our customers. Yet, the reward was never more than simply being able to do it for another year.

A year or so after the initial pain and shame of closing down subsided, I was reflecting on where we went wrong with my former business partner. His diagnosis was so clarifying and precise that I have never forgotten it: “Making money was important to us, but it wasn’t the most important thing to us.” Nearly a decade later, having ostensibly been a professional investor for most of that time, those words are ringing in my ear.

I have attended an investing conference with my friend Cal for the past few years. The conference is held in a small college town, usually with only thirty or forty attendees. The twenty-odd presentations range from stock pitches to philosophical inquiries to academic postulations. This year, one investor pitched MasterCard, trading at nearly 30 times earnings, and another pitched a Chinese biotech company whose name I forgot as soon as I heard it trading at 3 times EBITDA. These investors were considered thoughtful, judicious capital allocators by their peers. But, by the end of the day, after additionally hearing pitches for Zoom and a lengthy quantitative study of losing trades, it became evident that making money was not the most important thing for the vast majority in attendance.

Their jobs were to make money, and to a one, they would say they were focused on that goal to the exclusion of all others, but for most investors (myself included), this is a conceit that must be overcome. Some investors seek validation of their cleverness, others want to be rewarded for their piety to certain investing dogmas, and others crave the prestige and respect that comes from simply being entrusted with capital.

These are psychically necessary to a degree. The market can and will undoubtedly move against you at times, and for someone too emotionally wedded to their P&L, this can be existential. In the same way, these private motivations keep investors grounded; they can also blind them to paradigm shifts and make them feel entitled to specific outcomes. In a year where many investors found themselves on the wrong side of reason, it is worth reckoning with how to pursue investing in light of the human ego and the desire for order amidst entropy.

Every investor must arrive at their own distinction between gambling and investing. Speculation, as distinct from arbitrage, involves risking capital with uncertain returns. Even if true, the conviction that some risk may be mispriced does not guarantee positive returns. Likewise, the “prudent” path of passively investing in market returns guarantees merely average results that hold a similar disregard for uniformly positive results. Most investors claim they do not want to lose money, but in practice, they either take foolish risks to make it quickly or, with great discipline, lose it slowly.

There is no surer path to looking like a fool than to claim that a paradigm is shifting. Notwithstanding, I do expect a markedly different investment environment over the next 10 years. One in which public market investors will have to tolerate much greater volatility and far wider dispersion of outcomes for securities. Without the brisk tailwind of falling rates, assets will have to earn an economic return, not merely a financial one. That is, investments must perform above the cost of capital, with future profits and cash flows being more severely discounted.

Economist John Kenneth Gailbraith wrote of the permanently bullish, "[D]elusion lies in the conception of time. The great stock-market bull seeks to condense the future into a few days, to discount the long march of history, and capture the present value of all future riches.” Many investors, professional and amateur alike, have only known of a general upward trend in asset prices, a period where risk equaled return instead of being merely related to it.

Here, I must make a small, illuminating confession: The preceding paragraphs were initially written at the end of 2022! I won’t subject you to the trope of recounting the insanity of asset prices over the past twenty-four months, aside from mentioning that a $100,000 portfolio split evenly between Microstrategy and Bitcoin purchased at the time of writing would now be worth $1.3 million.

I’ve spent much of the past year wondering what, if anything, can be learned from this kind of rapid wealth creation, seemingly independent of the financial “gravity” that is supposed to envelope markets. The following are some still-forming thoughts to that end:

Volatility Leaks

This year demonstrated that asset price volatility is an extremely powerful force. While policymakers can attempt to suppress it, it cannot be eliminated and will effectively find ways to leak out both into markets and society. Where those leakages will express themselves is inherently unpredictable, be it the issuance of zero coupon convertibles to a company whose core business is in terminal decline or the assassination-style killing of a healthcare CEO on 6th Avenue. Volatility suppression is a form of financial repression that causes asset prices to come untethered, and the resulting, seemingly random, wealth creation sows social unrest.

Since the end of 2023, financial conditions have eased, first in anticipation of Fed cuts and then with their confirmation. Volatility came down concordantly, but it began spiking again in the summer of this year. Volatility is an input to measures of financial conditions, but I would argue that it's more of an output. Rates and liquidity are “fingers in the dike,” but eventually, volatility will find other cracks through which to escape.

Investors should monitor the degree to which volatility is or isn’t expressing itself in markets and consider ways to get exposure to it when it is inorganically low. For many, especially value-minded allocators, this will often mean having positions in securities that one would typically eschew or offering a few sacrificial bips to hedge the near-certain release. These positions can and should be rapidly monetized on volatility spikes, leaving maximum flexibility for purchasing dislocations and mispricings.

Shareholder Constituencies

The world of asset management is increasingly dictated by relative performance, either explicitly through passive investment vehicles or derivatively through index benchmarks. In addition to value, quality of management, and catalysts, the fundamental or bottom-up stock picker should be attuned to the make-up of the shareholder base.

This is especially important if you are drawn to out-of-favor securities. In special situations, deep value, or balance sheet-driven re-ratings, the ultimate driver of performance will be when a security moves from out-of-mandate to in-mandate for some larger pool of buyers.

Instead of lamenting that “the market isn’t getting it,” investors should work to develop a view on what conditions would make not owning a particular security a more active decision for institutional buyers.

Inflation is Hard to Measure But Easy to Know

We have seemingly left behind the world where inflation was just “low.” The Fed has conditioned us to believe below 2% is low, and thus the corollary that inflation above 2% is simply “high.” Every month, the financial press tortures the statistics into narratives that support falling, stabilizing, or rising inflation. High and rising, or high and falling, may “sell a lot of newspapers,” but I don’t think it matters nearly as much in practice as being suspended in high territory.

For an investor typically satisfied with merely respectable (as opposed to extraordinary) nominal returns, inflation and the real threat of financial repression should weigh heavily.

The Most Important Thing

At 15, I cajoled my parents into funding a $1,000 Scottrade account. The first security I purchased was Build-a-Bear Workshop . The company was on the leading edge of “experiential retail.” In brief, the concept was to create a premium experience via customization. A BBW customer would select, for lack of a better word, a hide that they would stuff and accessorize. The experience created a unit price at a significant premium to similar quality stuffed animals.

When I purchased those initial shares in 2005, the company generated $1.35 per share of earnings from $361 million in sales. Net margins were just 6-8%, but the company achieved more than $300,000 in sales per employee. If memory serves, my shares were purchased near $29, or a $500m market capitalization. To be clear, I was a high schooler who could barely spell DCF. My analysis was highly “Lynchian” -- a location had opened in a new mall near me, and I noticed it was consistently busy. I even purchased a bear for my girlfriend as part of my diligence. While she was neither impressed nor particularly pleased with the gift, I thought the experience was good. Additionally, there was some wisdom in retailing premium-priced toys, matching the per-store revenue of larger retailers with a much smaller store footprint.

The 21 times earnings I paid was a significant premium to the S&P’s multiple of 15. If I had intended to hold until today to earn an 8% annualized return, I would have needed nearly 10% earnings growth for the past 19 years, assuming the multiple compressed to the then-market multiple.

I ultimately ended up selling whatever was left of my position to pay for textbooks, but the stock has spent most of its (and my) life well below $29. In fact, at the end of 2020, the position would have been down 85%. However, in the glorious year of 2024, Build-a-Bear Workshop is up 90%. Moreover, it is trading at a sober 12 times earnings compared to the broader index’s 24 times earnings. Had I coffee-canned by BBW shares, I’d be looking at a 78% total return (3% annualized) inclusive of dividends.

Upon reflection, making money on my Build-a-Bear investment was important, but it was not the most important thing. I wanted to learn. I wanted to be right. But I also wanted to make mistakes. I wanted to pay the tuition for experience to get better. When do these motivations truly cease for the professional or committed amateur investor? If anything, they intensify as the market is reliably humbling. New motivations and drivers join them as you progress through your career. Left unchecked, these become deleterious to the task at hand. Howard Marks writes in his own The Most Important Thing,

The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.

The challenge isn't to eliminate our psychological drivers but to harness them and be humble enough to be honest about what drove them. The market will always be our teacher, ready with both rewards and humbling lessons. The question isn't whether we'll pay the tuition but what we'll learn from each expensive class.

- Hunter

Recently, BlackRock launched the iShares Top 20 U.S. Stocks ETF ( ). The day the fund began trading, my subway car into Manhattan was plastered with ads for the fund. “20 BIG STOCKS, 1 SIMPLE TRADE,” the copy read on nearly every imaginable surface. I have no idea if this kind of well-timed ad spend is a positive ROI for BlackRock, but I’m more interested in what it is trying to convey. 

Brevity and compliance restrictions prevent BlackRock from elucidating why you might want to own just the Top 20 companies by free-float adjusted market capitalization or why you should pay 20 basis points for the pleasure of having them do it for you. Ease is one clear message, but more so is the preponderance of BlackRock, with its $10 trillion of assets under management, as the investment manager de rigueur for the transit class. They made it, and now you’ll buy it. 

There are two important channels of communication in financial markets. One is between companies, governments, various securities issuers, and asset managers. The other is between asset managers and the savers whose funds they invest. How do the mediators of capital— the wealth advisors, pensions, and foundations, pick the relative winners in the great asset-gathering game?

Regulation, litigation, and competition sparked a devolution of investment management. The industry has taken on beauty pageant-like dynamics, where once subjective judiciousness aimed at identifying the exceptional has been reduced to a strict rubric that produces homogenous, uninspiring investment options. A crowded stage of wax figures all calling for world peace.

Style Boxes & Stars

In an earlier era, actively managed mutual funds were once the predominant investment vehicle. Before the rise of passive investing (to be addressed shortly), capital allocation aimed to identify superior investment managers. In 1985, a then-small Chicago-based company called Morningstar introduced a simple innovation: a five-star rating system for mutual funds. Seven years later, they launched an even more influential tool: the Style Box. Together, these two innovations would fundamentally transform how Americans invest their money.

Before Morningstar, investing in mutual funds was like navigating without a map. Every fund company used different terms to describe their strategies, making comparisons nearly impossible. The Style Box changed this overnight by introducing a nine-square grid that classified funds based on two simple factors: market capitalization (small to large) and investment style (value to growth).

The Star Rating system was equally revolutionary. By distributing ratings on a bell curve within each category (10% getting five stars, 22.5% four stars, 35% three stars, and so on), Morningstar created a universal language for fund evaluation. Though controversial for its backward-looking nature, the system's influence was undeniable—a single ratings change could move billions of dollars.

Asset management is a cascade of principal-agent problems. Most investment managers want to grow and retain the assets on which they charge fees. That means not getting fired by your clients. The easiest way to get fired is by looking too different from the competition and being wrong. The result is a lot of active managers who look very close to their respective benchmarks. This approach generates uninspiring investment returns but creates a more stable business for asset managers. 

Box Jumping

The Star Rating system gave managers a reason to take more active risk; outperforming their peers could lead to massive inflows. Of course, Goodhart’s Law, “When a measure becomes a target, it ceases to be a good measure,” took hold. A new paper, “Box Jumping: Portfolio Recompositions to Achieve Higher Morningstar Ratings” by researchers at Harvard Business School and MIT Sloan explains “mutual fund managers strategically alter their portfolios to take advantage of investors’ reliance on Morningstar star ratings.” 

In 2002, Morningstar made what seemed like a logical improvement to its mutual fund rating system. Instead of comparing all equity funds against each other, they decided to compare funds only against their peers with similar investment styles. On the surface, this made perfect sense – after all, why compare a conservative large-cap value fund against an aggressive small-cap growth fund?

The new system created nine distinct categories based on market capitalization (large, mid, and small) and investment style (value, blend, and growth). Within each category, funds would be ranked against each other. This meant a fund would only be compared against others pursuing similar investment strategies. When a fund moved from one category to another – say, from large-growth to large-blend  – Morningstar would immediately start comparing its historical performance against funds in the new category. 

“To illustrate our approach, consider the case of Goldman Sachs U.S. Equity ESG A (ticker: GAGVX). This fund was categorized as a Large Growth fund from December 2012 until May 2021, when it box jumped to the Large Blend category …. Despite a slight decline in its three-year trailing returns– from 14.5%  in April 2021 to 14.2% in May 2021– the fund’s three-year Morningstar rating increased  from three stars to five stars due to its new comparison group, which had worse historical returns. Following the rating upgrade, the fund experienced significant benefits. Notably,  it shifted from experiencing outflows to inflows, receiving approximately 1% of inflow per month in the six months after the box jump, compared to monthly outflows of-0.4% in the preceding six months. Additionally, the fund raised its management fee by 150 basis points after the jump.”

Overall, the researchers found that about 9% of Funds box jump annually. Those funds are twice as likely to receive an upgrade than a downgrade when box jumping. The rewards were substantial: successful box jumpers saw their assets under management increase by 6.7% on average and were able to charge 5% higher fees on average.

Before 2002, only 6% of funds that changed categories received rating upgrades. After the change, that number jumped to 48%. But there was a catch. The portfolio changes required to qualify for a new category often led to worse investment performance. Funds that engaged in box jumping typically saw their returns fall by about 21 basis points per quarter. Even more tellingly, the rating upgrades achieved through box jumping usually reversed within three years.

The statistical tools used to evaluate manager performance are a kind of financial phrenology that uses the shape of the past to make decisions about the future. Sharpe ratios, information coefficients, Sortino ratios, and Traynor ratios all describe how a manager’s returns relate to a benchmark, but there is no reason to believe that any manager can pursue high-risk-adjusted returns within the confines of these measures. 

The identity of risk and reward nearly ensures that great performance will come at the expense of the risk measures at some point in time. The capital allocator seeks a consistent framework to make, in the wisdom of institutions, prudent decisions. Morningstar provided such a framework.

Style Boxes & Star Ratings became an essential channel of communication between asset managers and savers. Were capital allocators such easy marks that a relatively rudimental stamp of approval substituted the kind of analysis their professions claimed to practice? In part, yes, the capital allocators have bosses of their own, and like the asset managers they invested with, they too, prefer to remain employed. There is career risk in allocating to poorly rated funds. 

But that was only the beginning of the “outsourced thinking” to come. Prudence itself was about to get a legal definition.

The Fiduciary Rule

The Department of Labor's 2016 Fiduciary Rule marked a crucial turning point by elevating the standards for investment advice in retirement accounts. The rule required advisors to document and justify their investment recommendations, emphasizing fee reasonableness. This regulatory change coincided with the existing influence of Morningstar's evaluation framework.

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In the news and in academic papers, you will often hear about “users of financial statements.” Who, exactly, is meant by users of financial statements is left to the reader. If you use the evolution of Generally Accepted Accounting Principles (GAAP) as a guide, the answer would appear to be short-term equity speculators. While that creates structural and idiosyncratic issues, it also creates an opportunity for investors who take an unconventional approach to security analysis. 

Under what Marty Whitman, founder of Third Avenue Management, called “the disclosure explosion,” GAAP transitioned from providing objective benchmarks to the much harder, arguably impossible task of capturing “truth” or “economic reality.” 

While earlier guidelines (pre-1970) focused on full disclosure, leaving interpretation to investors, later developments sought to prescribe what should be disclosed and how. Whitman believed the decisions that had to be made under the expanded GAAP regulations were better left to analysts, creditors, and competent investors than to financial statement preparers.  

As Whitman observed, GAAP had become more like The Internal Revenue Code, with rigid, complex rules. The key difference is that the tax code aims to arrive at a singular number: the tax liability, while GAAP is only meant to serve as a periodic benchmark of company performance and overall health.  The desire to establish an absolute framework has forced every company to report on a going-concern basis, meaning that cash flow and accounting earnings took primacy over the balance sheet and the building of corporate wealth. 

The distinction is not abstract. A company that is strictly a going concern relies on income statement flows — revenue and the resulting profits for its valuation and survival. However, in focusing myopically on the income statement, GAAP deemphasizes the company’s asset base, creditworthiness, and access to capital markets. Whitman from the July 2004 Third Avenue Value Fund investor letter:

“In fact, corporate and securities holders’ wealth is created in four separate, but interrelated, ways. To emphasize any one, or two, of the four to the exclusion of the others is to misunderstand corporate finance. And the present trend of GAAP is to overemphasize two factors – cash flow from operations and reported earnings – with a consequent de-emphasis of other factors that are at least equally important.”

The four factors involved in corporate wealth creation are as follows:

1.  Free cash flow from operations available for the common stock. This seems a relative rarity in the corporate world.

2.  Earnings where earnings are defined as creating wealth while consuming cash. This is what most prosperous businesses seem to do. Earnings may be of limited, or no, value unless also combined with access to capital markets to finance cash shortfalls. 

3. Asset redeployment and liability financing and refinancing. These activities include mergers and acquisitions, contests for control, diversification, the purchase and sale of businesses, the reorganization of troubled companies, liquidations, and spin-offs. 

4. Access to capital markets on a super attractive basis. Probably more wealth has been created through this venue than any other, ranging from the ability of real estate entities to finance on a long-term, fixed, low-interest rate, non-recourse basis to venture capitalists selling common stock into an IPO bubble

Today, GAAP focuses on 1 and 2, while 3 and 4 have been neglected or rendered unreliable by the rigidity of presentation requirements. Why? In Whitman’s prescient telling, the change followed a general market evolution. More assets began being managed in line with what he called Modern Capital Theory (MCT), now broadly known as the Efficient Market Hypothesis (EMH). 

Modern Markets

In such a market, asset prices are assumed to be “correct” until new information impacts them. As a result, reported earnings are “deemed to be far more important than what can be learned from studying and interpreting all of the other GAAP numbers available for a corporate analysis.” 

Whitman would hardly believe the intellectual and computing power now dedicated to positioning assets before and after companies’ quarterly EPS releases (saying nothing of the explosion of alternative data trying to gain an edge on those figures). Moreover, a growing share of assets are managed passively, leaving it to a smaller cohort of fast-money investors to set prices when new information is released. 

“In the current regulatory scheme, there seems to be much too much emphasis on controlling disclosure to meet the perceived needs of short-run traders. There is no question that capital markets are most efficient where the trading markets are free, fair, and orderly. However, fulfilling the stated information needs of short-run speculators really does not contribute to the maintenance of free, fair, and orderly.” - October 2006 Third Avenue Value Fund Letter

These trends have continued unabated since Whitman retired in 2012. In January of this year, Todd Baker, writing for FT Alphaville, flagged SoFi Technologies' choice of using fair value treatment for its loan book. While completely allowable under GAAP, the choice sets SoFi apart from its competitors. Most lenders use the more conservative amortized cost method with a provision for expected losses (CECL reserve). In fact, only six banks use fair value accounting, and SoFi’s assets represent 97% of the assets reported in this fashion. 

The company can recognize day-one revenue gains by booking loans at a premium to their unpaid balance. This choice also positively impacts SoFi’s regulator capital ratios. Baker, 

“The goal of fair-value accounting is to estimate a value that represents the price of the asset in an arm’s length transaction. But inherently, fair-value accounting involves assumptions and estimates by management which materially affect earnings and capital levels — if those estimates are “aggressive” or wrong, they could materially overstate both.”

The inputs to those estimates are unobservable, yet the outputs are blessed by an auditor. In the goal of having financials reflect “reality,” the expansion of GAAP, in this case, harms the face-value user of reported financials. Those users include not just retail investors, but also factor-based strategies that use standardized ratios for portfolio construction, regulators, and creditors.  

Implications for Real Asset Investors

There is a key analytical distinction between evaluating companies that are primarily going-concern-type enterprises and those that are investment-type companies. GCs and ITCs in Whitman’s parlance. While a GC is very much an income statement business that “consume cash to create earnings,” ITCs engage in balance sheet activities that include “asset conversions” like sales, refinances and M&A transactions that grow corporate wealth largely independently of accounting earnings. Real asset companies like REITs are much closer to ITCs than GCs.

Whitman provides interesting examples of how GAAP classifications can contradict this economic reality. He discusses Kmart, which carried $3.4 billion of merchandise inventory as a current asset. While this classification makes sense from an investment vehicle perspective (as the inventory would be converted to cash within a year), from a going concern viewpoint, this inventory is more akin to a fixed asset - something that must be maintained for the business to continue operating.

Similarly, he points to Forest City Enterprises, which carried $5.2 billion of real estate as a fixed asset. Whitman argues that many of these assets could be considered current from an investment vehicle perspective, as they could be readily sold or refinanced without interrupting operations. Of course, in the end, Kmart liquidated its inventory while Forest City was acquired by Brookfield. 

For ITCs, access to capital markets is the most important driver of business performance. Whitman, 

“Access to capital markets seems to be quite capricious. Loss of such capital market access by companies which needed continuous access was the precipitant for a large number of the biggest insolvencies in U.S. History: Drexel Burnham, Enron, Bear Stearns, Washington Mutual and Lehman Brothers” - October 2015 Third Avenue Value Fund Letter

Add Silicon Valley Bank & First Republic to the list now. To what degree did GAAP conceal or delay the discovery of the risk these companies carried? 

As GAAP has left the ITC investor behind, they have come to rely on various non-GAAP metrics to provide objective benchmarks. REIT investors must assess the assumptions and adjustments inherent in Funds from Operations, NOI, and leasing disclosures. These metrics are used primarily to divine the fair market value of assets but are more crucial in determining credit quality. Can the company continue to pursue asset conversion activities like turning cash into new cash-flowing assets? Will they be able to refinance their liabilities in an accretive way? 

Conventional security analysis does not offer much of a guide to answer these questions. Further, sell-side research, in responding to the needs of their largest clients, tends to focus on marginal beats and misses to these non-GAAP benchmarks. The long-term real asset investor benefits greatly from mispricings created in the wake of short-term-driven disclosure and the resulting trading. Whitman,

“For us, markets are taken as given, something investors take advantage of because they understand a business.”

For real asset investors, understanding the business is less about discounting cash flows (although that plays a part) and more about understanding how a company’s assets and liabilities may evolve over the coming quarters and years to support greater shareholder wealth creation. Whitman,

“GAAP, first andforemost, ought to be geared toward meeting the needs and desires of creditors rather than the needs and desires of short-run stock market speculators, who are vitally  interested in day-to-day stock market price fluctuations.”

It behooves all real asset investors to take this credit approach and view GAAP as limited, perhaps even flawed, especially in its current form. The users of financial statements should err towards a “modified convention of conservatism,” which tends to understate profitability and asset values. The “analyst’s job is to adjust those understated, objective GAAP figures to the analyst’s version of economic reality.” That’s hard, but if there is an art to investing, it is in having a differentiated view of reality that comes closer to the truth than the market.

In Transitional Capital, I briefly touched on the securitization of Home Equity Agreements. Asset-backed securities backed with “esoteric” collateral are growing in popularity as the mandate for debt strategies expands.

Just last week, Carlyle entered into a partnership to Unison to purchase $300 million of HEAs. Earlier this month D2 Capital led a $280 million Series B round for Unlock, another HEA originator.

I will admit to some ever-increasing fascination with these types of financial instruments. Debt markets seem uniquely capable of always finding new grist for the mill.

Despite a near-constant chorus of “Bubble!” from housing bears, the case for structurally higher home prices has remained unchanged for the past decade. Limited supply growth and declining affordability have increased home prices through business and credit cycles. 

Such consistent performance has unsurprisingly attracted investment capital. In addition to outright institutional ownership of rental homes, the desire to somehow fractionalize or securitize exposure to residential price appreciation has spawned countless start-ups and structures. Jeff Bezos-backed Arrived, the perenially dogged Divvy, and double-unicorn Roofstock have all tried to streamline and distribute various forms of passive investment in residential homes. Nearly all have struggled despite the macro tailwinds for residential pricing. Coverage of VC-backed Landa highlighted the myriad inherent challenges of “democratizing” residential investing. 

Meanwhile, the Home Equity Agreements (HEAs) market has quietly thrived. In recent years, substantial expansion in the HEA market has been driven partly by rising interest rates that have made traditional refinancing less attractive to many homeowners. A March 2024 TransUnion publication underscores the market's potential, which estimated a staggering $22.1 trillion in tappable home equity across 86 million U.S. consumers. This vast pool of untapped equity represents a significant opportunity for continued growth in the HEA market. 

The market has evolved through stages of institutionalization towards becoming a distinct asset class. Just last week, private equity firm Carlyle announced an investment in HEA pioneer Unison and a commitment to purchase $300 million of newly issued equity-sharing agreements from the firm. Today’s letter will take a look at:

• The history and growth of the HEA market

• Nuances within various HEA contracts

• How capital markets are developing for these assets

• Potential future innovation around home equity investments

Read the rest on Thesis Driven with the 50% off coupon below for Lewis Enterprises Subscribers.

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Thesis Driven

The Institutionalization of Home Equity

Despite a near-constant chorus of “Bubble!” from housing bears, the case for structurally higher home prices has remained unchanged for the past decade. Limited supply growth and declining affordability have increased home prices through business and credit cycles…

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2 years ago · 2 likes · Hunter

Today’s memo is an extension of a white paper I co-authored with Robby McDonald of Cherry Lawn Capital. Transitional Capital focuses more on real estate-related consumer finance companies, but the ideas and concepts are applicable across the real estate operator space. Additionally, trends around financialization and the evolution of asset management touch on many of my prior posts. You can find the paper at the link below:

Transitional Capital Whitepaper

Apollo’s Scott Kleinman spoke at the Barclay’s Financial Services Conference earlier this week. In the seemingly inexorable rise of private credit, Apollo has appeared prescient in positioning its credit business to benefit. Apollo’s yield-focused assets under management have grown by $140 billion since Q2 of 2022 or nearly 20% per year. Kleinman told conference attendees, 

“[T]he single most important factor for an alternative asset manager is origination capacity…That is the single biggest constraint on growth, not capital formation, not how many people you have. It really is built around can you originate enough attractive assets to meet your needs.”

To say that capital formation for credit is “not a constraint on growth” is no small statement. The demand for debt securities in a lower growth, higher rate environment has driven credit spreads lower, even as bankruptcies and other signs of credit strains have mounted. A few weeks ago, I argued that we are in the early stages of a secular trend toward debt-led capital markets. Where does that leave real estate? 

A VC once told me, “Ideally,  capital structure will match whatever is the alpha factor of a given cycle.” Equity, specifically venture equity, was the ideal capitalization for a momentum-driven regime. Should we find ourselves in an environment where high prices no longer beget higher prices, yield and spread become the alpha factor. That has significant implications for real estate firms, for whom relatively cheap equity was once abundant.

Over the past 18 months, many real estate operators have seen that a levered equity model cuts both ways. Most have stayed glued to charts of the 10-year treasury, anticipating a “return to normal” when the legacy model would again drive capital formation around real assets. I liken it to learning a card trick, then one day finding that the trick no longer works. Instead of learning a new trick, they wait anxiously for the right cards to pop out of the deck again. 

The Old Model 

Fundamentally, there are two proven business models in real estate: Be an asset-light operating company that either leases or manages real estate for a fee or be a principal owner of real estate engaged in asset management activities. The former has been historically funded by traditional or venture equity. The latter has taken a private equity approach, putting real assets in either funds or SPVs and participating in the resulting fee streams. 

The tension of “OpCo” versus “PropCo” financing has left both types of firms stranded by their respective capital providers. The rapid rise in interest rates and the resulting decline of real estate asset prices froze both the venture capital and real estate markets simultaneously. Further, there appears to be a structural shift away from capital willing to take on the equity mandate. Even GP stakes investing, which is nominally equity, relies on the inherent leverage of LP capital. 

Skeptics may point to the growing pool of real estate “dry powder,” claiming pent-up demand for real estate equity. I would argue that much of that dry powder will be deployed in more structured ways, either by taking REITs private or via JVs like the recent Sixth Street & Plymouth deal. Further, undeployed private debt mandates outstrip all alternative asset classes except traditional private equity. 

The bottom of capital stacks is shrinking, both because of a lack of actual risk capital available and the unrelenting demand for assets that can reasonably check the “Credit” box. The traditional view is that we are in the late stages of a credit cycle, that a “Minsky Moment” will lead to rapid contraction of credit that again makes equity a better risk versus reward proposition. This assumes that the capital allocation mechanism works to capitalize assets efficiently. I would argue that financial markets have effectively crowded out this response in favor of security creation. 

What if real estate operators leaned into their role of fundamentally being asset originators? In an earlier era where bank lending dominated real estate debt, operators served the role of creating bank assets. Today, the demand for debt has shifted from banks to new types of firms and forms of securities, and as Kleinman points out, demand is robust. Debt secured exclusively from the cash flows from real estate will remain constrained by the shortage of equity described above. If capital markets are hungry for debt, give them something they can lend against.

A New Form of Real Estate Capital

In forming capital around real estate assets, firms create various fee streams and real estate-related assets in both the Operator and Principal Owner space. Those fee streams and the control rights of real estate represent untapped potential for security creation that could at least partially supplant traditional equity, funding the OpCo and PropCo simultaneously.

Imagine a sponsor of primarily industrial assets capitalized in the conventional private equity structure. The sponsor OpCo collects asset management fees, has claim equity performance above a hurdle, and may also have property management or other origination-like fees.

Those fee streams are contractual and, except carry, unrelated to underlying asset values or investment performance. The sponsor could theoretically pledge them as collateral against a loan, further enhanced by managerial control of the assets. A $100 million portfolio of assets might produce $1.5-2 million per year of fee income when accounting for the accrued performance fees. With a weighted average deal life of five years, the discounted value of the fee streams at 8% is ~$7 million. The sponsor could, in effect, securitize a portion of that value to equitize either their OpCo or to serve as new equity in the PropCo. 

Asset-light real estate companies, broadly “PropTech” firms that leverage technology applied to real property ownership, face a similar challenge when capitalizing assets. These companies are developing solutions for accessing home equity, operating sub-institutional assets, or managing passive real estate investments that created hybrid structures with technology elements and an asset management component.

These businesses are not merely building portfolios of real estate assets; they are also creating new cash flow streams from management fees, servicing rights, and options that are unique assets derived from real property ownership. While traditional real estate finance has yet to evolve to serve these firms, the burgeoning Private Credit market creates new opportunities for companies that can originate new assets at scale.

While it elides a concise definition, private credit is essentially any debt originated outside of the traditional banking system. In this way, real estate pioneered private credit. Debt funds, hard money lenders, and mezzanine providers were all early innovators of what would be recognized as private credit. Yet, the capitalization of real estate businesses remains siloed in an older model of capital markets. I expect private credit will lead in evolving lending to real estate operators under the umbrella of “fund finance.”

These structures share similarities with the growing GP stakes business, where investment firms buy equity positions (effectively, future contractual cashflow streams) in alternative asset managers. However, this collateralized approach takes the basic leverage embedded in GP economics and transforms it into a debt instrument for which a large and developed end-buyer market already exists.

Private Credit is Expanding Its Horizons

If this seems obtuse (or even fanciful), you need to look more closely at what is happening in the private credit space. With traditional private equity-backed LBOs sidelined, private credit wants to expand its remit aggressively. In my March review of the Grant’s Private Credit Conference, I recounted John Zito’s entertaining french fry analogy:

“John Zito of Apollo Global Management, used French fries and Wikipedia to illustrate the point. French fries, he explained, take a variety of forms and can be prepared in a multitude of ways. He noted that the Wikipedia page for French fries has a word count of nearly 4,000 and has been edited over 1,400 times. Private credit, undoubtedly more complex and varied, has just 500 words and less than 100 edits. Zito's point, "We need to make private credit more like French fries,” meaning that the investment community should appreciate and segment the multiple expressions of private credit, which is after all, just lending.”

That has meant an intentional foray into asset-backed lending. Banks and other institutional investors have historically financed debt related to education, car loans, equipment, and credit cards. Private capital is now getting more creative, looking at assets like music royalties, movie rights, and the kinds of assets originated by real estate sponsors.

According to an April Bloomberg report, asset-backed deals collateralized by “unusual collateral” have risen considerably in the post-pandemic era1, 

“Esoteric ABS deals — backed by collateral other than student, auto, credit card and equipment loans — have risen to about 31% of the ABS market from 9% over the last decade, according to Barclays Plc. Collateral pools have also become more diversified, with investors seeking out novel structures to earn excess returns as ABS spreads tighten, dropping more than 30 basis points since November. Meanwhile, interest rates are expected to stay higher-for-longer, meaning the benefits to borrowers of waiting to come to market have dissipated.”

Mike Nowakowski, head of structured products at Conning, told Bloomberg that the relative lack of historical data usually demands concessions to the benefit of investors. He added that insurance companies have started looking more closely at these deals as they get more creative with deploying capital.

Creating New Asset Classes

The combination of new financial products and a growing pool of assets with debt mandates has led to increased demand for debt origination outside of the traditional categories. The institutionalization of Home Equity Agreements provides a useful guide to how nascent financial products can ascend the capital markets. 

The Home Equity Agreement (HEA) market emerged in the early 2000s as an innovative financial solution for homeowners. Pioneers like EquityKey and FirstREX (later Unison) introduced this concept, offering homeowners a way to tap into their home equity without taking on debt.

As the 2008 financial crisis reshaped the lending landscape, HEAs gained traction as an alternative to traditional home equity loans and HELOCs. A Home Equity Agreement (HEA) is a financial arrangement where homeowners sell a portion of their home's future appreciation in exchange for a lump sum of cash today. Unlike traditional loans, HEAs don't require monthly payments or accrue interest. Instead, the investment company receives its agreed-upon share of the home's value when the homeowner sells the property or buys out the agreement, typically within a 10-30-year term. 

This market saw significant growth in the 2010s, with new players like Point, Hometap, and Noah (formerly Patch Homes) entering the scene. These companies leveraged technology to streamline the HEA process and expand accessibility.

By 2024, the market had matured, with established leaders like Unison and Point competing alongside newer entrants such as Unlock Technologies and New Avenue. These companies had to innovate their funding models to continue to grow their portfolios alongside their operating companies. Until recently that has meant a mix of private real estate investment and growth equity. 

Now, seven securitizations of Home Equity Agreements have come to market, representing nearly 10,000 originations. The most recent HEA-backed issuances from Unlock and Hometap, have each been rated by BBB (investment grade) Morningstar DBRS. These securitizations represent an important advancement in the creation of a more robust alternative credit asset class.

Home Equity Agreement Securitizations 

What this Means for Capital Providers

If capital formation for debt is broadening, anyone responsible for allocating capital should take note. As increasingly esoteric debt exposures come to market, investors must consider whether their risk exposure is novel and if the limited data surrounding it creates opportunity.

The growth of alternative and private assets has revealed that the fee business's cash flows are considerably more stable than those from the underlying investment exposure. Capitalizing a growing asset management platform is a distinct bet from capitalizing the platform's assets.

For real estate, there is a flywheel in which unlocking new liquidity can drive asset prices and the fee streams they generate. This form of what might be called “transitional capital” suffers no setback should the appetite for equity return. Other alternative asset classes have undergone some version of this evolution—venture capital begat venture debt, which helped bridge companies to new equity rounds. Private equity has long used subscription lines, and now, NAV lending to leverage their platforms for continued growth.

In my experience, the arrow of financialization moves in one direction. I recently found some writing I did over a decade ago in which I was deeply concerned about leveraged loans from the broadly syndicated loan market finding their way into ETFs. A decade later, these products have neither blown up nor have they ever posed any real systemic risk. I can hand-wring about Apollo trying to put private credit assets into an ETF, convince myself it is a late-cycle phenomenon, or I can at least consider that markets evolve.

The nature of private asset ownership is changing, and investment management is becoming its own ecosystem of value creation. In The Distribution Layer I wrote,

The largest managers have provided a release valve for unprecedented liquidity but now find themselves with a similar deployment challenge as the capital they manage.

My overall thesis was that capital deployment would become more mediated, with smaller alternative managers incorporated into a broader investment management value chain. Financing the growth of asset management platforms allows larger pools of capital to leverage their strength in capital formation while smaller managers focus on what has always been their core competency: asset origination.

On March 22, 2021, the Financial Times headline read “the New Berkshire Hathaway?” The firm in question was Apollo Global Management and its pending merger with life insurance company Athene. Perhaps it was the interrogative form that spared Apollo from the curse of comparison with the Oracle of Omaha; since publication, shares of the alternative asset manager have risen 150%, trouncing rival Blackstone (93%) and the S&P 500 (39%) along the way. 

The tone of the article danced on skepticism. By 2022, alternative asset management had firmly established itself as a Very Good Business™️. What was once a cottage industry of gunslingers had grown to control some $5 trillion of assets. These firms were capital-light, collecting rich fees using other people’s money to buy companies, real estate, and infrastructure. This model used both explicit leverage and the implicit leverage of LP capital, which created asymmetric payoffs for the managers when things went right. Because their clients were mostly institutions, they benefitted from a light regulatory touch. 

Insurance, by comparison, is capital intensive, has a low margin, and is highly regulated. For years, alternative managers have been happy to help insurance firms manage a portion of their assets, but being one themselves held little appeal. The FT noted that bringing an insurance company fully onto the balance sheet would surely weigh on Apollo’s valuation multiple. Under the large tent of insurance, there is a spectrum of liabilities ranging from simple to actuarially complex. Complex liabilities include products like long-term care insurance, property & casualty lines. Simple liabilities are more akin to investment products like annuities and pension liabilities. 

Annuities guarantee a given income level at retirement. Other annuity types track hedgable benchmarks, but in sum, these products provide insurance companies with long-duration, more or less fixed-rate liabilities. In turn, insurance companies invest 80-95% of this capital in investment-grade debt, seeking to earn a small spread between their investment returns and funding costs. The remaining 5-15% can take more risk, investing in equity and other alternatives. For years, alternative managers focused on managing this small sliver of insurance capital. In bringing Athene fully onto the balance sheet, Apollo would earn meager spreads on the investment-grade book but have captive control over all of the risk (equity) capital portion.

Now, virtually every alternative asset manager is trying to recreate the Apollo flywheel. But this model did not rise out of the ether of financial engineering, a culmination of factors converged in ways that will potentially alter both financial markets and society. The aftermath of the GFC saw bank lending severely restricted. Meanwhile, rates began a downward march to the lower bound.

This created growth in the private credit asset class for alternative managers. For insurers, it severely impaired the economics of their annuity business. With each passing year, rates fell below the rates at which policies had been originated. Before long, insurers began offloading these assets at sizable discounts to appease public shareholders, who were growing increasingly worried about the imbalance.

Few people foresaw what Apollo CEO Marc Rowan was building. Rowan’s innovation was using the equity portion of the insurance balance sheet to seed new debt origination platforms with equity. Those platforms could themselves benefit from the traditional private equity LP structure while also originating assets that could feed both the investment-grade and equity portion of the insurance balance sheet. Commentator Red Deer has an excellent deep dive into the details of this structure but in brief,

“In summary with this model, you have the following: $5 in insurance company equity paired with $5 in sidecar equity supports $5 in insurance company equity assets. $5 in insurance company equity assets supports a ~$7 evergreen fund (70/30 split). A $7 evergreen fund supports $14 in specialty finance company equity (50/50). So, $5 in equity drove $14 in equity investments…Moreover, the leverage in the insurance company makes every dollar of growth in the insurer generate a multiple of equity capital to invest, further multiplied by the introduction of incremental OPM at every stop in the value chain.”

With demographics driving the growth of the annuity business and increasingly onerous bank regulations opening up the lending market, Rowan had created something of a financial perpetual motion machine. PR Pro Josh Clarkson of Prosek Partners writing in The Alternative Investor, 

“In the years that followed, others saw the attractiveness of this model and launched or bought similar platforms. Many of these originally grew through purchasing existing locks of insurance from insurers looking to reduce their exposure to certain areas, often at attractive valuations given public investors' distaste for these exposures at the time. As the popularity of this strategy grew, the valuations for such blocks, and for annuity platforms, have increased, and now many alts-backed insurers both purchase blocks and originate new organic business through multiple channels.”

Other alternative managers and hedge funds tip-toed into the market, setting up insurance shells to buy the liabilities and earn the spread for themselves, but none had taken the bold approach of fully integrating an insurance business. Simultaneously, the assets dedicated to alternative strategies grew precipitously, again, on the back of falling interest rates.

By 2020, the largest private equity firms had captured virtually the entire pie of institutional assets. Their continued growth depended on finding new assets, and many began looking downmarket to the private wealth channel to attract equity to their products. This strategy admittedly had some low-hanging fruit, but the distribution and investor relations functions were expensive and burdensome for firms that had been built on capital-lite models.

Buying insurance assets was an expeditious way to grow assets with the caveat that only a portion of the capital could be deployed into an alternative firm’s core offering. In essence, every $1 of purchased insurance assets created ~10 cents of new equity for alternative managers, so they needed to buy lots and lots of insurance assets. By contrast, the Apollo-Athene model showed how this channel could be exploited to create 30 cents or more of new equity with each new dollar of insurance assets. Further, the new debt origination platforms you seeded feed investment-grade assets to the insurance capital. An ouroboros of capital flows was hence created where new assets beget new assets in a symbiotic cycle of debt origination. 

Sea changes in financial markets are not always obvious. It is now undeniable that open market share buybacks have had an impact on equity markets, but little was made of the adoption of the SEC’s 1982 10b-18 rule that created them. Such, I believe, is the case with the marriage of non-bank debt origination with insurance liabilities. It upends the economic identity that investment is a function of savings. Annuitants forgo traditional savings, therefore increasing their capacity for financed consumption; that consumption becomes the feedstock of debt origination. Increased consumption also creates growth, increasing the demand for debt assets as the resulting capital seeks a home. Financialization, defined simply, is the demand for debt assets in the absence of productive uses of that debt. Debt creation equitized by insurance liabilities is an End State of financialization. 

All forms of debt borrow from future growth. When that growth fails to materialize, new debt is needed. As diminished expectations weigh on returns, yields need to be structured to continue to attract capital. Structured finance takes a given yield and then tranches it into a priority of payments, creating higher and lower-yielding securities by breaking risk and reward up into new buckets. The riskiest of those buckets is the equity tranche, which bears the first loss in the event of a payment shortfall. Insurance-led credit origination takes a debt, the annuity liability, and uses a portion of it to serve as the equity of new debt vehicles. 

The complexity of this arrangement doesn’t obviate the role of equity; it inverts it. Economically, equity plays a key role in resource and capital allocation. Traditional equity derives its value from corporate performance and its future prospects. It is the “front line” of capitalism. Debt follows equity in this process of capital allocation. Debt is at least partially defined by equity. It is the existence of the junior claim that gives the senior claim its currency. 

Equity in the insurance model is more akin to a derivative or an option that derives its value from asset prices and credit spreads. Alternative managers run this equity through a GP/LP structure that further disambiguates business performance from investment outcomes. Under this model, equity exists to serve the creation of debt. Resource and capital allocation are not front-and-center. This form of finance values greater origination volumes both to support asset prices and to feed new assets into the top of the insurance balance sheet. 

Marc Rowan, speaking at the Bernstein Strategic Decisions conference in May, said, 

“So we go back many years. We were a really large, fast-growing Athene with a smaller origination platform. Athene took 100% of everything. Okay. That was great to start. Now the curves have reversed….And we're doing what you would expect us to do. We're diversifying. Athene does not want 100% of any risk. They want 25% of everything and 100% of nothing. So we built a third-party insurance business, and then we built a third-party institutional business, fixed income replacement business. And you will watch us do this in retail. You will watch us do this in interval funds. You will watch us do this in ETFs. We have a whole interesting world out there, but it all starts with -- the ecosystem doesn't work without origination. That is what is in short supply.”

Rowan conveys clearly what I’ve described above—broadly distributed equity claims that support debt origination. So, where is this all headed? A dystopian view might be a world where there are no savings-funded investments; rather, savers purchase insurance products like annuities. Those insurance products are fed by the debt created from savers’ levered consumption. Equity is created as a result of the insurance product structure and then fed back into the process. 

This system undermines the belief that the capitalist system works via the capital allocation feedback mechanism. Asset prices are continually supported by the self-perpetuating demand for debt instruments. In fact, has pointed out that credit spreads have remained perplexingly tight even as other signs of financial distress have risen. 

Without credit contraction, asset price reckoning is forstalled. This reduces the theaters of speculation to corners of the market without debt-driven asset prices -- cryptocurrency, venture capital, and a smaller cohort of traditional equities. Savers are increasingly attracted to instruments that offer defined outcomes that truncate the distribution of returns (insurance products in a different wrapper). 

While I understand the temptation to call such a market “unsustainable,” I don’t think it necessarily leads to a dramatic collapse. A more likely path is the continued degradation of returns as malinvestment is allowed to continue for longer.

The classic capital allocation cycle, where booms and busts shift investment to better allocators, is constrained because more “savings” are effectively locked in insurance products. There is definitionally lower volatility, but as an extension, lower returns.

In the fully realized version of this system, there are only two financial functions or roles: Insurance Buyer and Asset Originator. I will leave it to you to decide which is a better proposition.

Disclosures

This report is intended to be educational and entertaining, not investment advice. Do your own due diligence. I make no representation, warranty, or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report.

Any assumptions, opinions, and estimates expressed in this report constitute my judgment as of the date thereof and are subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. Lewis Enterprises is not acting as your financial advisor or in any fiduciary capacity.

At the time of this writing, I own shares of Apollo Global Management. My own positioning is subject to change without notice.  

Demand in the Digital Age

When Sam Altman debuted SORA, OpenAI’s text-to-video product, the announcement and subsequent public fervor felt eerily familiar. In fact, the entire OpenAI product rollout has felt reminiscent of a time in consumer tech not so long ago. It was a time when a professorial Steve Jobs would stand on a minimal stage and unveil the latest iteration of the iPhone, or a tablet, or sometimes an entirely new suite of must-have electronics. I would refresh MacRumors on my first-gen iPhone to see the latest updates and technical specifications. Could the naked eye really detect the marginal improvements in speed and screen resolution? It didn’t really matter; the frontier was coming rapidly into view, and you could be a part of it. 

Artificial Intelligence (AI) adoption is not all that different from the task Jobs and Apple faced a decade ago. It hadn’t previously occurred to me that I needed my phone to be a guitar tuner or a level. Prior to the SORA release, my ability to summon images of dolphins riding bicycles on command had not felt limiting, but the path of technology turns possibility into necessity, into inevitability. 

I am not interested in adjudicating the technology's value, nor am I qualified to predict its path of development. I am concerned with how this technology will be distributed into an economy that has struggled to generate growth in real capital, how intellectual property and computing power available to a small handful of firms can be transformative, and what makes AI different from previous technological step-changes.  

Canadian-American economist, diplomat, and public intellectual, John Kenneth Galbraith provided a model for evaluating these questions two generations ago. Galbraith served as a professor at Harvard University and in various political roles, including U.S. Ambassador to India (1961-1963) and key advisor to Presidents Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy, and Lyndon B. Johnson. Galbraith challenged conventional economic wisdom, emphasizing the importance of countervailing powers and the influence of corporations on consumer behavior.

As untold billions flood into the AI ecosystem—into data centers, chip foundries, and development and model training—what capital—financial, human, political—is being simultaneously deployed into demand generation? AI seems to be on a perpetual PR campaign, but one defined by conflict and contradiction. 

The future with AI is bright but also possibly dangerous. AI will revolutionize the industry, but deployment seems focused on consumer adoption. The main theme of this campaign is that AI is going to change everything, infusing itself into daily life in unimaginable ways. We are to simultaneously believe that AI will be like a utility, yet the firms developing it and its requisite components are the most valuable in the world. The Henry Ford aphorism “If I had asked people what they wanted, they would have said faster horses,” is a familiar defense of speculative innovation, but AI finds itself continually having to prove and promote its qualitative superiority. 

The New Industrial State

Both classical and neoclassical models of economic growth have three basic inputs: Capital, Labor, and Technology. Long-run economic growth ultimately springs from technological progress. The definition of technology, as is common in economics, is impressively broad. Technology includes things as fundamental as fire and row cropping but also microchips, personal computing, and fission. Beyond the scope of economists, it accounts for virtually all of the strange magic that is human progress. 

Capital and labor are somewhat fixed and difficult to alter without considerable turmoil. Technology arises more or less exogenously and improves the productivity of the other inputs. It provides new platforms and infrastructure for industries that didn’t previously exist. Jobs like “app developer,” “podcaster,” or “SEO expert” were not options twenty years ago; high-speed broadband and mobile telephony made them possible, and entrepreneurial creativity took care of the rest.  

The narrative of broadly shared productivity gains was more or less self-evident for much of the 20th century. Technological progress distributed among diffuse small firms in rabid competition led to fantastic economic growth. However, as early as the 1950s, the structure of the US economy began to change. Small firms were superseded by large firms, industrial behemoths that commanded their markets with ever-growing aegis. These firms’ control of both supply and demand was near absolute. Galbraith coined this dynamic as “The New Industrial State,” and he took to task many of the core assumptions of economic growth. 

Central to Galbraith’s theory was that large industrial firms do not risk facing traditional market forces. They do not produce speculatively. Both the time and capital employed in large-scale production would not occur without assurances about the demand for that output. To Galbraith, the New Industrial State was just as preoccupied with generating demand and assuring prices as it was organizing and controlling the means of production.

Unlike fire, row cropping, broadband internet, or mobile telephony, AI is neither a technique nor a platform. It is coveted intellectual property, created at great expense and wholly owned by the firms that develop it. It can’t be built upon like traditional infrastructure; to build an AI product is to consume an AI product. 

The Technostructure

Galbraith referred to the collection of scientists, engineers, marketers, and other specialists as the “Technostructure.” Galbraith's concept of the technostructure refers to the influential group within organizations that possesses specialized knowledge and expertise, enabling them to shape decision-making and wield significant power. 

The Technostructure plays a crucial role in determining the direction and priorities of the organization. The Technostructure's power stems from its ability to control information, set goals, and influence consumer demand through advertising and marketing.

No particular conspiracy is required; no secret cabal needs to meet and coordinate. The modern firm, by siloing talent and controlling resources, accomplishes a dual goal of ensuring its continued ascension while minimizing the potentially disruptive influence of the traditionally capitalist entrepreneur.

Mythmaking around its progenitors has been a cornerstone of the AI PR campaign. The idea that a small menagerie of scientists, visionaries, and entrepreneurs are bringing AI into the world as though it were a divine mission or moral imperative has been sufficiently implanted but the technostructure of AI more closely resembles a mid-century IBM than it does a late-Seventies Apple Computer. 

“The real accomplishment of modern science and technology consists in taking ordinary men, informing them narrowly and deeply, and then, through appropriate organization, arranging to have their knowledge combined with that of other specialized but equally ordinary men. This dispenses with the need for genius. The resulting performance, though less inspiring, is far more predictable.”

These initiatives have been funded and supported by the largest technology companies and investors in the world. Our desire to valorize and mythologize “a couple of guys in their garage” has created a sense that we are all participating in the forging of an unknown frontier. The more likely reality is that AI is merely a component of an intensely planned end-market. 

"Technostructure has emerged as the indispensable planning unit in the modern industrial system. The need for planning arises from the long period of time that elapses during the production process, the high investment in specialized equipment, the inflexible commitment of that equipment to the particular task for which it was designed, and the need for a large organization to which people of diverse skills and functions are committed."

The Perfect Consumer Buys in His Sleep

Galbraith believed that “consumer sovereignty” had meaningfully deteriorated in this New Industrial State; that the economic notion that consumer demands, whether physical needs or psychic desires, were met by entrepreneurs innovating and organizing to meet them, had been upended.  

As society moved beyond subsistence living, consumers required new motivations for consumption. Traditional economics leans on a concept of price-defined utility that is easy to understand in the abstract -- a hungry person places a higher utility on food than leisure -- but harder to parse for post-scarcity affluence. To Galbraith, this sovereignty, where consumer preferences guide production, had been inverted. Galbraith called this the “Dependence Effect” -- that wants ultimately become a function of production. 

“As a society becomes increasingly affluent, wants are increasingly created by the process by which they are satisfied.” 

This helps explain the focus on AI’s consumer-led adoption and how it blurs the line between product and service. AI exponentiates the classic production function, turning its outputs into a funnel for more inputs. AI’s users provide it with the feedstock for its models. The more we use AI, the more robust and desirable its outputs become  -- “wants created by the process by which they are satisfied.” 

But what are those wants? Did consumers and the industry suddenly become consumed with passion for chatbots and derivative image generation? 

“If the individual's wants are to be urgent they must be original with himself. They cannot be urgent if they must be contrived for him.”

Galbraith would hardly believe the current state of what author Shoshanna Zuboff called “Surveillance Capitalism,” the extraction and commodification of personal data for the express purpose of selling. Zuboff writes, 

“The logic of surveillance capitalism begins with unilateral claims to private human experience as free raw material for production and sales. These claims are supported by a radical indifference to what is taken, an indifference that is justified by the logic of the machine at the expense of the interdependent needs of people and society."

This idea is particularly relevant in the context of AI-powered products and services. As consumers interact with AI systems, such as Large Language Models (LLMs), voice assistants, or smart home devices, their preferences and desires are continuously shaped by the outputs of these technologies.

Moreover, AI removes the normal impediments to consumption. Our attention, motivation, or sleep (the last frontier of consumer capitalism) that typically constrain exchange between sentient parties melt away. If adequately supplied with enough information and given sufficient sovereignty on its own, AI can consume by proxy. 

AI is itself a voracious consumer. It requires outsized quantities of both power and water to run through a scarce supply of real estate in the handful of areas even capable of supplying either. Yet at present, flagship AI applications are free to use or can be upgraded for less than the cost of most news subscriptions. An inherent contradiction is that AI is both cheap to use but maddingly difficult to create and enormously expensive to operate.

Subsidized consumption is nothing new, but in earlier iterations, the end game was clear. Uber would operate at a loss to drive out competition from legacy providers, whereas AI is deploying into a greenfield market. A sort of inverse Jevons Paradox is forming, where the technology starts its life as cheap to use, and only after sufficiently embedded is its true cost passed on. Galbraith, 

 “[I]f production creates the wants it seeks to satisfy, or if the wants emerge pari passu with the production, then the urgency of the wants can no longer be used to defend the urgency of the production. Production only fills a void that it has itself created.”

After the last customer service department has been disbanded and after the final studio closes, AI can be profitably deployed. Another form of rent extraction fails to generate the broadly shared economic growth that the classical model promises from new technology. Interactions that were once mediated and limited by human capacity will be carried out more or less continuously and subject to a royalty that covers the upstream requirements of the underlying capital.  

Fewer Demons

As Galbraith would say, “The point is so central that it must be pressed.”  While AI may have tremendous utility, it is a product whose production is the justification for its use.

Potential advances in the productivity of low and medium skilled workers, or even their potential obsolescence, would set AI in a more classical economic context. Had our own knowledge work ascended to levels that made these tasks so rote as to be mindless, we could view AI as we now do spreadsheets or e-mail.  Had we found ourselves newly in need of masses of copywriters, data entry clerks or graphic designers, the great movement of capital that brought AI to the fore could be seen in a new light. Instead, we face an aggressively marketed solution applied to glibly defined problems of human capacity. 

This view does not require one to be a techno-pessimist, nor a Luddite. I used a Large Language Model at various points in the composition of this very essay. I am optimistic that in time these technologies will lead to key breakthroughs for challenging problems in health care, energy production and education. 

Galbraith’s view challenges us to see these technologies not as portals, but as mirrors. The path of AI distribution and development relies on our human fallibility and our psychic discomfort in an affluent age. In that analysis, those important breakthroughs likely exist somewhere on the other side of more precise consumer credit ratings, more intrusively targeted advertising and the continued proliferation of various forms of vice.

Investing Implications of Artificial Intelligence and Machine Learning

In the world of pensions and endowments the preponderance of asset allocation as the primary driver of returns is practically a truism. The wisdom of this approach was codified in Harry Markowitz’s Modern Portfolio Theory and further lionized by Yale’s David Swensen who added then-exotic “alternative assets.” Real assets, private equity and hedge funds with their disparate correlations to stocks and bonds unlocked the allocators’ holy grail: Higher returns, with less overall risk.

Alternative assets have benefitted unusually well from this approach as periodic rebalancing between the more volatile public asset classes and the optically stable private markets almost always meant a fresh flow of capital. Bond yields’ 30-year downward march and the post-GFC growth in equities meant allocators were constantly topping up private allocations.

The increasing flows meant more capital chasing the underlying assets which bolstered returns. Those steady returns, driven mostly by multiple expansion, are now creating a fundraising challenge. Without a bust, there can be no boom.

Shannon’s Demon

What follows here is a very abbreviated description of Claude Shannon’s concept. I highly recommend checking out RQA’s or Portfolio Charts’ more detailed write-ups.

Despite the mathematical complexity of Modern Portfolio Theory in practice, its primary feature is nicely illustrated through Shannon’s Demon a thought-experiment developed by MIT mathematician Claude Shannon. Richmond Quantitative Advisors,

The general idea behind Shannon’s Demon is that two uncorrelated assets, each with zero expected long-term returns, can actually produce a combined portfolio that consistently generates positive returns if intelligently balanced and rebalanced at regular intervals.

Imagine a fair coin, when flipped you can either make 50% or lose 33.3% making the long-run expected return of the game zero. Start with $1,000, flip once, win $500, flip again lose $500 ($1,500 x .666), back at $1,000.

100% Coin Portfolio

50/50 Coin-Cash Portfolio

If instead of betting $1,000, you bet $500, keep the other $500 in cash, also with a 0% return, and diligently “rebalance your portfolio” after each flip into 50% coin outcome, 50% cash you can transform two assets with 0% expected return into a portfolio that generates an ~8.4% return.

Volatility Drag

The experiment demonstrates the impact of volatility, and more specifically volatility drag, on portfolios. Richmond Quantitative Advisors,

To better understand volatility drag and the power of it, assume you have $100 to invest.  In the first year, you make a 10% return.  Then in the second year, you lose 10%.  Intuitively, many people would think you’re back to breakeven, but you’re not.  You’re actually down 1% from where you started – $99.  Moreover, the greater the size of these return swings (i.e. the greater the volatility), the more the volatility drag increases – and it grows exponentially!  For instance, if your return swings were 20% instead, then you’d be down 4% after the second year.  Even though volatility only doubled (10% to 20%), the volatility drag quadrupled (-1% to -4%). 

By rebalancing into an uncorrelated asset, in this case cash, you reduce the volatility drag substantially. That volatility reduction allows you to collect the geometric, or compounded return of 8.4% versus the arithmetic mean, or average return of zero.

It is a neat trick, but aside from the obvious simplifications relative to real-world investing, the coin and the outcome are known with certainty at the end of each flip. The messier world of institutional investing does not have this luxury.

Disrupting the Demon

While the return profiles and correlations get more complex, the basic management of institutional assets follows the logic of Shannon’s Demon. Allocators assess returns and then dutifully rebalance back to the target allocation. If equities are down big, like in 2022, funds are allocated to them to bring the portfolio back into balance. Allocators may make some tactical shifts to justify their existence, but substantial changes to the investment policy are herculean, politically fraught endeavors.

The issue arises for private equity when the coin just never lands. There has always been some question the degree to which private equity was actually less volatile or merely disguising the volatility through infrequent valuation. The considerable uncertainty and likely loss of value within real estate in particular not yet reflected in private marks is beginning to get uncomfortable. Globe St. reports that pension allocations to real estate funds are down 50% this year,

The tally from commitments to funds and separate accounts last year was the lowest since 2013, when pensions gave less than $28B to CRE and the fourth-lowest total since Ferguson Partners began tracking the sector in 2011,

Traditional buyout firms and venture capital aren’t faring much better where the Financial Times reports that across private equity, fundraising is the lowest it has been since 2017. The FT,

However, after a decade-long industry boom, private equity groups have been struggling to sell portfolio investments and to convince investors to lock funds up for long periods with high fees attached.

The same reflexive nature that powered private equity’s growth now threatens to be its undoing. In the seemingly interminable cycle that began a decade ago, investors have grown accustomed to “V-shaped” asset recoveries. Private equity did not rush to mark-down assets, which would jeopardize their trademark stable values if new highs powered by lower rates were always just a quarter or two away.

That impulse has disrupted Shannon’s Demon. The volatility drag isn’t being rebalanced away, it’s being carried. The rebalancing that would occur with a realistic assessment of Net Asset Values drives the reversion to the mean that Modern Portfolio Theory relies on. Capital would flow into sectors with depressed pricing and those assets would get bid up.

Dry Powder

Much has been made about the uninvested capital still sitting within private equity vehicles. These sums are cited either as proof that the party can go on, or simultaneously that it’s winding down. In reality they represent a sort of stalemate. It is hard to buy assets that look very much like the ones you already own for attractive values while maintaining that yours are not similarly valued.

Ultimately transactions, not models, set prices. While the stalemate can’t go on forever, certain palliative solutions have arisen. The growth of secondary funds to buy existing LP stakes as well as the rising popularity of co-invest vehicles that have lower fees and focus on deal-by-deal acquisitions are currently taking the place of fresh fund capital.

Volatility Transfer

The industry may get another form of bailout in the form of surging public equity values. Not only do all-time-highs shift the denominator in favor of greater private exposure, but IPOs may offer the liquidity currently absent from private markets.

Recall, Shannon’s Demon is an illustration of reducing volatility drag by rebalancing between assets with different correlations. When private equity obscures the underlying volatility it doesn’t disappear, it merely gets carried along.

Moving it to a more volatile asset class via public offering brings the system back into balance. The 2021 SPAC boom provided a preview of this for venture capital excesses. Now expect public markets to absorb the detritus and carried volatility of private equity and real estate. On Apollo’s ( ) latest quarterly call, CEO Marc Rowan said that he “sees an opening” to push private capital into the 401(k) market. Rowan,

It's limited by a risk mentality as a result of substantial litigation over a long period of time, but I think we're seeing a stabilization, particularly as the set -- suite of private products is no longer all high fee, high carry, locked away in funds.

You're watching the first baby steps as fiduciary managers in 401(k) begin to mix-in private into their, heretofore, public solutions simply to get better outcomes and better diversification.

If successful, private equity can print the returns that have powered its growth through the decade. But if the carried volatility can’t be offloaded and hits the asset class, asset allocation assumptions that created a growing pie of capital for decades may be re-evaluated. Private equity should have let the coin land.

Further…

The emergence and growth of GP Stakes investing is the latest of late-cycle phenomena, a motley chimera of structures used to amplify the productive output of the private equity options factory.

When you take out a mortgage to buy a home, you are shorting the bond market to go long housing. When you pay life insurance premiums you are rolling a put option on your life expectancy. Recently in Europe, I was offered the opportunity to pay for dinner either in US Dollars or Euros at an exchange rate that reset nightly, innumerate travelers no doubt creating a nice spread business for someone.

Most everyday transactions are really financial abstractions. It is not necessary, or even practical, for people to think in these terms. You do not need to run Black-Scholes on your international bar tab. They are useful simplifications that reduce the inherent frictions of global trade. For financial markets, these transactions are the raw material for instruments that hedge, speculate or leverage capital into more capital. For financial market participants, breaking investment returns down to their component parts and understanding them isn't just an interesting thought exercise -- it's the entire job!

Private equity is no exception, neither in its aims nor its abstractions. Said plainly, as interest rates fell, allocators at large capital pools needed highly levered exposure to equity beta but were institutionally incapable of tolerating the attendant volatility. Private equity offered to abstract away that volatility in return for a compensation structure that created an asymmetric payoff for the sponsor: An option.

Creating a structure where LPs could effectively sell volatility has been a runaway success across asset classes. In 2012, private capital fundraising was under $500 billion annually, in 2022 that figure was $1.4 trillion. Growth of private capital has meant a proliferation of alternative asset management firms in increasingly niche markets. Meanwhile the upper tier of the market has been consolidating1. As I wrote in The Distribution Layer, "The largest managers have provided a release valve for unprecedented liquidity but now find themselves with a similar deployment challenge as the capital they manage." Non-control stakes in emerging firms “GP Solutions” or “GP Stakes Investing” solves a deployment problem with an elegant, high operating leverage solution.

In a typical structure a private equity firm, the GP, earns a management fee but more importantly begins to participate in the profits above a predefined hurdle rate, "the carry". The investor, or LP, is effectively ceding this portion of their profits to the GP. This ceded value was "sold" in return for the productive efforts of the GP, the benefits of being a limited partner wherein the maximum loss is contributed capital and for laundering the volatility of the underlying investments.

In theory, the GP takes on greater risks in this arrangement, exposing herself to legal liability, possibly staking unrelated assets or operating the partnership at a loss in the hopes of breaking into the carry. The theoretical portion is that sponsor size and creative structuring has largely negated these risks for most institutional GPs. Today the market, like many, is one of brands, access and relationships. Risks to institutional GPs, to the degree they exist at all, are largely reputational.

Take this entire dynamic, nest it inside of itself and you have GP Stakes investing. Asset management firms raise funds to purchase interests in other, usually smaller or middle-market, alternative asset managers. Institutionalized GP stake investing was pioneered by Goldman Sachs' Petershill Partners. Goldman set up the unit in 2007, bringing it public on the London Stock Exchange in 2021. In practice, family offices have done some form of the strategy for decades.

Initially, there was a degree of adverse selection and misalignment with investee LPs as the deals were more akin to aggressive financing structures that offered a little capital for large interests in the management company. Today, the strategy is positioned as "GP Solutions" with more manager-friendly structures and ancillary support to grow the business. As defined by alternative asset manager and leading GP Stakes investor Blue Owl (Dyal),

A minority owner’s interest is usually permanent and entitles the holder to a share of the GP’s cashflow, which is generated by the fees and carried interest charged on the GP’s funds as well as returns made from investments on the GP’s balance sheet (i.e., the GP’s co-investments in its own funds).

Why would the largest asset managers pursue this strategy and why would a growing alternative asset manager be interested in selling off a portion of their management company? Not surprisingly because it is a novel form of leverage for all involved. The emergence and growth of GP Stakes investing is the latest of late-cycle phenomena, a motley chimera of structures used to amplify the productive output of the private equity options factory.

The Commenda Then and Now

Every industry, including finance, is beguiled with the notion of building "platform" businesses, consultant-speak for an asset light structure that collects economic rents from intellectual property. For private equity, the intellectual property is not so much novel methods or technology, but rather the brands, reputations and relationships that generate deal flow and raise capital. Deal flow, that once extruded through the private equity form, creates the option-like security of the GP stake. This creation of new financial assets is nearly totally abstracted from the underlying asset owners, the pensions, endowments and now high-net worth investors that are fund-level LPs.

When viewed as an options creation exercise, the incentives for private equity sponsors begin to look different. The earliest origins of what we know today as private equity began with Italian merchants and the commenda2. A land-based merchant (the stans) would entrust a seafarer (the tractator) to ship goods to another port, sell them and return with the profits. In a unilateral commenda ( a mere-commenda) the tractator would be entitled to somewhere between one-quarter to one-third of the profits. In a bi-lateral commenda, or one in which the tractator also contributed capital, the profits would be split 50/50.

This structure sought to align the incentives of the parties at every level. The tractator was taking on significant, possibly mortal, risks. The stans, or merchant, could not compound capital in a local market, and as their wealth grew, would need to trade in progressively further markets. The stans risked their capital and bore 100% of the financial losses, while the tractator's time, talent and appetite for danger afforded them upside with no financial commitment. Capital and labor thus came together in a mutually beneficial arrangement. That broadly the shape of this arrangement persists today speaks to its natural logic, "lindy" as it were.

This logic is distorted however when the goal is no longer the generation of investment returns, but rather the generation of ever more commenda contracts. With risks to the GP all but eliminated, bootstrapping options and then further selling off stakes in the bootstrapping operation begins to significantly divorce itself from the goals of investing capital. Many GP stake deals come with a follow-on commitment to provide regular-way LP capital to future funds, a further enticement to grow and deploy LP capital.

Of course, every asset management firm wants to grow but a natural constraint on growth is investment performance. If a firm's investments perform, they can attract more assets, the profits from realized carry helping to support the growth of the organization to invest the now larger pool of capital. A large and growing base of capital buying GP stakes distorts this important feedback loop of capital allocation. Selling a GP stake is quite literally borrowing the rewards from unknowable future investment returns. Per consulting firm Maketa,

The primary purpose referenced by GP stakes managers for minority transactions is to provide capital for growth initiatives. This additional capital might be used by the GPs to make a larger commitment to their funds (to enhance the alignment of interest with LPs), to establish new products (which may require the addition of new teams), or to expand platforms (e.g., targeting a new asset class in the private markets or a new geography).

Private equity firm GCM Grosvenor says that can the "[h]alo effect from institutional capital provides critical validation to the manager in a highly competitive market for capital and talent." Then, without the vaguest sense of irony points out,

For LPs, one of the most compelling cases for seeding is historical data that demonstrates outperformance of earlier fund vintages. Based on aggregated data for buyout funds, a Fund I net IRR outperforms established private equity funds by an average of ~280bps

So GP stakes are great way for private equity firms to accelerate their journey to mediocrity? The GP stake investor has effectively bought an options creation platform. Spread across enough managers and fund vintages this creates a perverse form of leverage. LP capital is grist for the mill in which losses in the underlying funds are pushed down to LPs, while the upside ascends through layers of waterfalls. Attempts to reconcile incentive alignment are increasingly futile as the system becomes preoccupied with the creation of financial assets to the detriment of prudent capital allocation.

Victorian banker, essayist, and journalist Walter Bagehot wrote, "[w]e must not confide too surely in long-established credit, or in firmly-rooted traditions of business...We must examine the system on which these great masses of money are manipulated, and assure ourselves that it is safe and right.”

Capital without an economically productive home will resort to the creation of financial securities and abstracted layers of risk re-distribution. Private equity, long exhausting the gains from levering up equity beta, has resorted to increasingly arcane structures to solve a growing deployment problem. Un-abstracting those structures reveals simply more exotic forms of leverage.

Further…

“The most beautiful thing that ever shouldered a load! It rides and handles like a convertible yet hauls and hustles like the workingest thing on wheels.”

- Chevrolet Motor Company

Everything is a bond.

The source of most investment returns can be condensed down to a combination of coupon, credit, duration and convexity. The distinction between debt and equity as an outside passive, minority shareholder (OPMI in Marty Whitman language) is largely legal, partially philosophical and practically non-existent. Will you get paid back, how much, when and how are the basic inputs of every investment. The structuring of financial instruments is really a practice of tweaking these inputs to solve for both company financing constraints and investor appetite.

The periodic resurgence of zero-coupon convertible bonds is a personal curiosity and a signal that the market's conception of the basic investment inputs has been distorted. Companies like this source of financing as a way to take advantage of inflated share prices that doesn't immediately dilute shareholders or strain leverage ratios with new debt service. In reality, the true cost of zero-coupon convertibles reflects their hybrid nature. When factoring in hedging costs and the future dilution, the cost of this form of capital tends to fall between debt and equity.

In the summer of 2003, Yahoo stock was up 47% year-to-date, while the US 10-Year Treasury yielded just above 3%. Yahoo issued $750m of 5-year zero coupon convertible bonds for general corporate purposes. Yahoo stock traded around $24 per share and bond holders would be able to convert into stock at $41 per share, a 68% premium to the share price at issuance. If bought at par, Yahoo shareholders would earn a 0% return unless the stock rose above $41. "Yahoo is getting an excellent deal," Jeremy Howard of Deutsche Bank told Bloomberg at the time.

At this point it may be of some value to explain why a non-convertible zero-coupon bond is not inherently an absurdity. Lest you maintain the provincial notion that debt is always accompanied by cash interest payments, the market for Zero Coupon US Treasuries is large and liquid.

Issued at a discount to par, Treasury Zeros expose investors to greater duration than a similarly dated Treasury that pays a coupon. These are good for investors who are tuning the duration of a portfolio, matching liabilities, or are particularly sensitive to the tax implications of regular interest payments. The yield on zeros is captured in the discount to par where the bonds are sold. A 5-year zero coupon with a par value of $100, might sell for $78.35, a 5% yield-to-maturity.

Everything is an option.

When a company layers in the conversion rights, they are selling two financial instruments in one: a straight bond and call option. For bonds with no coupon, the value of the option offsets the discount to par. As a CFO of a company with volatile shares, the zero-coupon convertible is almost irresistibly elegant as it monetizes the equity volatility in the form of a loan, the cost of which will be borne sometime in the future.

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Untold trillions are managed based the foundational assumption that stocks and bonds are negatively correlated. The possibility, the mere suggestion, that this correlation might instead be positive impacts everyone from public pensions to college savers, to the clients of financial planners.

The "prudence" of this assumption is practically codified in law; acting as though it is absolute truth is a matter of fiduciary responsibility. But as Unlimited Funds’ Bob Elliott notes, it is an historical aberration that bonds were such good diversifiers.

The past two years have demonstrated an abject failure of "60/40" portfolios to achieve their stated goal. The obvious objection would be that 24 months is not an adequate time-period over which to judge a portfolio strategy, but that does not make any attempt to explain why asset behavior has changed so much. How could yields rise so dramatically with such little impact on equity valuations? Bill Gross writes in his latest commentary,

S&P 500 forward P/E multiples have for the last 5 years been correlated to real 10 year Treasury yields with the exception of the last 12 months or so. There is a long-term logic for this. A P/E ratio turned upside down to E/P is really an earnings yield. One might commonsensically assume that if bond yields go up by 350 basis points that (everything else being equal) earnings yields (E/P) should follow somewhat. They did until the Fall of 2022 as the chart will show but not since.

uses the 30 Year TIPS yields to show the cognitive dissonance investors are experiencing.

Expressed differently, guaranteeing real purchasing power gains over the next 30 years has become substantially cheaper in the last 18 months. And yet oddly, we see little evidence that this has impacted the valuation of equities.

Gross and Green both identify the thin reeds upon which the equity market may be hanging— the potential for inorganic growth from fiscal spending, an AI-fueled productivity boom, or some secret third thing that powers corporate earnings. All possible, but perhaps pollyannish in the face of rising capital costs and other exogenous shocks.

The biggest issue with this explanation though is the high level of agency it assumes on the part of investors. Let's go back to the original premise: A huge number of assets are managed with essentially no discretion. Target Date Funds, Model Portfolios, and fiduciarily mandated asset allocations are all based on the belief that past is prologue in terms of correlations. Green:

If the dominant mechanism of asset allocation shifts from one where bonds and equities are considered to be substitutes (I can own EITHER bonds or equities based on forward expected return and risk) to one where allocations are FIXED based on the use of historical distributions and correlations, the behavior of asset markets changes markedly.

Extending this dynamic on to a market where the supply of Treasuries is increasing due to monetary tightening and deficit finance, but where many investors are indifferent to yield or relative valuation, creates an obvious distortion.

Quantitative researcher Steve Hou identified another interesting dynamic between bond yields and correlations six years ago. From Hou's abstract:

I find that the elasticity of bond risk premium with respect to supply depends on the correlation between stock and bond returns. An increase in the supply of Treasury bonds raises the required bond risk premiums, but the effect is stronger as stock and bond returns become more positively correlated.

Bond risk premium is a strange beast as it is not directly observable, but conceptually it is the spread investors require for holding long bonds. Hou's paper provides academic backbone for what markets are now experiencing. As bonds lose their utility as a hedge, investors require higher yields to shift their allocations. This creates a reflexive loop for quantitative tightening; higher rates beget higher rates.

But which is it? Are investors not responding to higher yields because they are structurally passive, or are the yields on offer simply not high enough to shift allocations to bonds that no longer offer diversification? What about institutions that are more attuned to the risk exposures of their portfolios?

As Green points out, for asset-liability matchers like insurance companies, higher rates are a boon, reducing their discount factors, but “[p]erversely, this LOWERS demand for bonds even as they become empirically more attractive.”

In a recent interview, Hou refers the inevitability to today's predicament, the specter of recession and subsequent rate cuts as a "Damocles Sword" hanging over the market.

Today a new Damocles Sword hangs over the market: The magic bond yield at which investors will be jarred awake and begin dumping equities to buy fixed income.

Bill Gross,

Unless Chair Powell and company can significantly lower real 10 year Treasury rates from 2.25%, investors may eventually realize that bonds are a better deal than clearly overvalued stocks headed into an economic slowdown/recession.

Those same passive dynamics could begin to work in reverse, or as Mike Green says,

This means that bonds can become incredibly cheap relative to US equities, but the reversal is likely to be quite violent if we see investors eventually challenge these allocation models.

For now, investors are enjoying the feast. When will they look up?

I believe the future of alternative investments is meaningfully in flux. These thoughts are based on my own participation in the market, as well as conversations with emerging managers and associates at the largest alternative managers. I should also note that much of my time is spent in the real estate sector and many of these views are shaped by trends in that particular asset class. Nonetheless, private equity, credit, and to some degree hedge funds, are navigating changing end markets for their products. Those closer to the ground may disagree with this assessment and I’d be eager to hear an alternative narrative of how the next decade may play out. My view focuses largely on how the market structure will change with regard to investment managers, allocators, and ultimately the owners of capital. 

A new BCG report ominously titled “The Tide Has Turned” points out that 90% of the asset management industry’s revenue growth has come from market performance versus inflows. Alternative investments offer an irresistibly hot dot of growth that promises large greenfield retail markets and less fee compression. 

BCG recommends traditional asset managers internally build or buy alternative investment platforms. I believe they are looking for growth in a market that has already outgrown itself in many ways. The largest managers have provided a release valve for unprecedented liquidity but now find themselves with a similar deployment challenge as the capital they manage. The top five public pensions have over $1.5 Trillion in total assets, while the Top 5 U.S. alternative managers have $2.6 Trillion of assets under management. That is only to say that to the degree that investment returns come from exploiting inefficiencies, massive capital deployment begins to degrade forward returns.

To this point, the largest alternative managers have been able to capture a consistent flow of these assets precisely through their ability to deploy capital at scale. That enviable product is possible only through the magic of manpower. At Blackstone, the real estate investment headcount alone is over 1,000 professionals, a number that understates the true scale of the operation as model maintenance and other rote underwriting tasks are outsourced to cheaper labor in developing markets. 

The hand-in-hand growth of pension and endowment assets and large alternative asset managers now faces a triad of headwinds. High and rising rates are changing the role of alternative strategies at defined benefit plans, mid-career investment talent is looking at crowded, relatively younger, upper echelons of their organizations, and asset growth via high-net-worth and private wealth channels requires larger and more developed investor relations functions.  

Greater Intermediation of Capital

Despite weakness in traditional markets, the “denominator effect” has been muted, if not non-existent, at large pools of capital. The structural dominance of alternatives and the glacial pace of change at public bureaucracies is working in favor of the largest managers for the moment. However, performance faces its own rate-driven headwind and will eventually cause a reevaluation of investment policies, and ultimately, greater intermediation of capital allocation. Institutional capital will go in search of the inefficiencies large alternative managers can no longer provide. This is an important development because simultaneously the top mid-career talent at large alternative managers will leave to start their own firms in an effort to make more interesting investments and to access more remunerative general partner economics. The layers between capital and assets are going to increase and specialize. 

This will open up capital to emerging managers across asset classes, but today’s managers must start with a more diverse capital base that includes institutional capital, HNW/Private Wealth, and OCIO relationships. Absent a change to the market structure, alternative managers face one of the classic business challenges: Selling into multiple markets at once without sacrificing product quality or brand. 

Today, you have emerging alternative managers building what are essentially DTC brands on social media, established firms utilizing crowdfunding sites to diversify their capital bases, and independent advisors getting aggressively marketed alternative strategies by their traditional investment providers. The challenge of a more fragmented, or intermediated, market of capital providers is that the investment business begins to demand increasingly sophisticated “distribution.”

Distribution is a bit of an anachronistic term in asset management that harkens back to a Golden Age of Wirehouses. Distribution is, in fairness, still regulatorily captured by broker-dealers. For the largest asset managers, this regulatory relic is a trivial detail and an even more de minimus cost of rolling out retail-ready products that can profitably accept smaller checks1. 

For smaller managers though it can be both a significant cost and meaningful distraction, especially if their AUM does not support a large organization. Firms like iCapital and CAIS have tried to fill this void by taking on some of the administrative and marketing burdens of accessing more retail dollars. But these platforms still lean heavily on the brand strength of “Blue Chip” alternative asset managers, while respected, but not-yet-household-name, firms struggle to attract assets. 

These disjointed sales channels and access points are clearly not an end-state for the market. The current fragmentation is creating temporary profit pools for those offering “access” to something that is already broadly accessible, just confusing and poorly mediated. Marketing to retail investors is costly and risky without more certainly around customer lifetime value. Retail capital is notoriously fickle and running illiquid strategies that rely on it has a long history of failure.

The Distribution Layer

I believe there will be a growing Distribution Layer of capital allocators that sit between investment managers (both emerging and established) and investors (both institutional and retail). Registered Investment Advisers “RIAs”, specialized fund-of-funds (FoFs) of various structures, and Outsourced Chief Investment Officers (OCIOs) will all inhabit this layer. These all exist today, but I believe they will be the actual growth market within the private capital landscape. They will grow in number, assets, and overall importance to the market over the next decade. 

The language of “access” will continue to lose currency, while mediation, diligence, and process will attract capital. While the largest managers will maintain their relationships with institutions directly, they will access private wealth and retail channels through a Distribution Layer. Established and Emerging managers will sell products into a Distribution Layer that faces these firms in a more traditional B2B relationship format. 

Platforms like iCapital or CAIS have a tenuous first-mover advantage. They provide commodity infrastructure and back-office support for investment managers, but the role of investor relations, communications strategy, and marketing still falls primarily on the managers. This is the key benefit to managers of a growing Distribution Layer: It is a largely homogenous group that can all be marketed the same product, with the same language, and the same sales force. 

Institutional capital will be attracted to the Distribution Layer as a way to scale their own allocation efforts towards portfolio optimization, greater diversity, and more inefficient sectors of the market. An OCIO or sector-specific FoFs will offer a way for institutions to continue to deploy large checks but do so in a more diffuse way.

Perhaps most importantly, the Distribution Layer will also act as a clearinghouse for capital with different durations. Liquidity concerns will be handled at the distribution level, not the investment management level where illiquidity is a key driver of returns. Currently, managers are having to innovate new, often clunky, sub-optimal versions of their strategies to accept capital of varying liquidity expectations.

Capital will flow into the Distribution Layer where firms will build allocations from different buckets of capital, allowing investment managers to focus on investing and institutional allocators to focus on tuning and optimizing their portfolios. 

Early Iterations

Institutions are currently supported by a consultant ecosystem that provides a governance prophylactic for institutional decision-makers, but they are not principals like the firms that will occupy the Distribution Layer. Some RIAs and Multi-Family Offices are performing distribution-like roles, either via captive Fund-of-Funds or by convincing alternative managers to aggregate smaller checks but face the investment manager as a single LP. 

Interval funds are making inroads into the Distribution Layer as accessible allocators to private assets. This structure is not without drawbacks2, but it does fit the profile of being able to continuously accept and allocate capital from diverse capital sources with varying liquidity requirements. 

Sector-specific allocators and Fund-of-Funds will also be able to attract assets as key players in the Distribution Layer. Private equity, real estate, and credit are asset classes with high transaction costs and considerable friction. Specialization within these categories is a forgone conclusion, but with specialization comes a more limited capacity to deploy capital at scale. Fund-of-Funds and similar structures with asset class-specific mandates help institutions optimize exposure without expanding internal resources. 

Interestingly, the largest alternative managers have had limited success in participating in the Distribution Layer themselves. Assets under management at Blackstone Hedge Fund Solutions, which allocates to external hedge fund strategies have grown at a much slower clip than their core Private Equity and Real Estate offerings. Carlyle Group purchased AlpInvest in 2011 ostensibly as a bolt-on secondaries platform but has evolved to provide “Investment Solutions” via primary, secondary, and co-invest private equity investments to institutional clients. At the time of the acquisition the firm had $43b of assets under management, 12 years later AUM is only $68b, growing just 4% annually since the acquisition. Despite anemic growth thus far these may prove to be valuable business units, but I still believe there is a broad mandate across the capital spectrum to achieve greater manager diversity within the alternatives sleeve.

Impacts

A perfectly reasonable argument against this view is that a focus on minimizing fees will prevent a new layer of intermediation from forming. I would argue that running multiple sales channels, disjointed access points, and spinning up internal IR teams is adding considerable cost to the overall system. The Distribution Layer requires no regulatory disruption or moonshot technology, just growth capital to capture the opportunity. The business model of charging a nominal percentage of assets is well beyond proof of concept. 

I think the most salient change to the market will be how investment firms position themselves in the market and the investment strategies they ultimately choose to pursue. Today, firms must shape their offering to an impossibly broad set of capital providers. The end-state Distribution Layer will afford managers the freedom to specialize, pursue truly inefficient markets and take advantage of time-limited or capital-constrained opportunities.

In the previous two decades building an investment business meant building a capital-raising machine more than developing a process generating investment returns. Gathering assets will always be a crucial function within firms, but it shouldn’t supersede the task of making great investments. My most pollyannish view is that the Distribution Layer will allow investment firms to focus on developing the best possible investment programs, and those processes will serve as the chief content that allocators will look for when making their decisions. That’s starkly different from the current state where the path to growth is quickly spinning up a product to catch flows from an undefined, shifting glob of global capital. 

If not, I still believe the canard of access will give way to greater mediation and thoughtfulness around alternative allocations. Global private equity is about twelve times the size of the public markets. Progressively later state venture capital and the growth of buyout firms have deprived public markets of many of the fastest-growing and best-value companies. At some point these assets are no longer “alternative” but core to earning equity risk premium.

The growth of alternatives is less about attracting investors to something new and more about adjusting their allocations to something that is. That evolution will demand new skills, new firms, and new practices throughout the investment value chain.

Further…

Public markets, not unlike public libraries, offer a clear social benefit yet if they were not already established it is hard to imagine their creation in the present. That a median wage earner with relatively little administrative friction can purchase equity stakes in some of the “best companies in the world” is beautifully egalitarian. In an age of secularly low interest rates, the ability to participate in economic growth via public equities has created retirement security for millions of Americans. Public agencies regulate trade, mediate the flow of information, and distribute reasonably robust disclosure. None of this seems like it could feasibly develop today, yet the wonder of public markets faces accelerating senescence.

Capital formation has been dominated by private capital post-20001. The growth in private capital has infiltrated every corner of the economy. Whereas the early LBO market focused on industrial or “old economy” businesses, private equity and venture capital offer an alluring path of financing for everything from early-stage technology to real assets and infrastructure.

Private capital offers the benefits of patient capital, less onerous governance, and crucially, less disclosure2. In an economy where the precision and fidelity of data can separate industry winners and losers, the ability for certain knowledge to remain “proprietary” offers a meaningful competitive advantage. Around the same conference table, a private equity real estate manager might share with a European PE boss that industrial companies in the region are more aggressively expanding their footprint.

Moreover, certain parts of the value chain can theoretically be captive to the same equity interests, making previously thorny conflicts less limiting. In 2019, the world's largest private owner of commercial real estate, Blackstone, recapitalized commercial property restoration company Servpro. Should, for example, a hurricane inflict damage on a Blackstone-owned property in Miami, resources can be martialed from portfolio companies like Servpro to get those assets back online faster. The growth in private debt markets means private equity firms can and do often occupy multiple levels of the same capital stack. Ignoring briefly the potential fiduciary issues, captive capital markets provide a clear advantage to the providers of that capital.

The effects this increasingly concentrated ownership has on the economy is the subject of intense debate. The argument that private equity adds value by imposing greater corporate discipline is belied by the fact that in recent history growth in asset values has come primarily from multiple expansions relative to margin improvements.

What is undeniable is that it has deprived public markets of these assets, and thus savers from the subsequent returns. Whether through luck, leverage, illiquidity, or “volatility laundering” private equity has outperformed public markets by approximately 400 basis points per year.

That the bulk of private capital comes from public pensions has been something of a raison d'etre since the asset class began growing in the 1990s, the reality though is that only 13% of the working population has or is expected to receive some form of defined benefit retirement. Endowments are another major private equity investor but those funds benefit an even smaller subset of the population.

Paradoxically, following the GFC, many of these private equity managers converted from partnerships to corporations and found their way to public markets. Once public, growth became the motivating factor for maintaining enterprise values. Instead of fighting over the fixed pie of pension and endowment assets, they turned their focus to high-net-worth and private wealth channels. These clients were ostensibly retail investors but were usually guided by financial advisors or other intermediaries. Regardless of their fiduciary status, private equity saw that these advisors could be a de facto sales force for their funds.

A lot like the difference between First Class and Coach, individual investors may be on the plane, but they aren’t in the front. Because these private equity firms do not want to build out large, internal investor relations departments they have sub-contracted the work of selling, processing, and servicing smaller investors to outside firms that spin up feeder funds and handle the deluge of paperwork required to make investments in private funds. This leads to higher transaction costs and worse experiences. While a pension fund director may be getting wined and dined by GPs, the individual investor will be paying an extra layer of fees, have little if any direct contact with the underlying managers, and wait longer for performance reports and tax paperwork. High-net-worth investors will have to assess whether the allure of higher returns and infrequently marked prices makes sense in their portfolios, especially in structures that are simultaneously cumbersome yet watered down.

For everyone else, the growth in private equity has corresponded with the degradation of public markets. In an earlier era, the IPO was the holy grail for companies with business models that had a tangible path to sustainable growth and profitability. Today, the public market is mostly an avenue for greater speculation, purchasing scrip on businesses that may generate cash for shareholders many years in the future. Low rates have meant all manner of specious businesses have been able to raise extremely low-cost, permanent capital from individual investors seeking any real return. A favorite James Grant quote,

Needing income, investors will take imprudent risks to get it. And if 2% invites trouble, zero percent almost demands it.

Even the prudent path of passive investing finds itself exposed to novel risks and challenges. The largest companies in the S&P 500 now have market capitalizations in the trillions, are generally concentrated in technology, and account for a greater and greater share of returns. For those returns to continue, these companies must find the same magic of generating high returns on invested capital when incremental productivity improvements from technology appear to be waning.

Where does this leave the average saver? With undoubtedly diminished expectations. As rates have risen, the equity risk premium has narrowed substantially, yet bonds still do not offer yields with assuredly positive real returns. In fact, monetary discourse has shifted to maintaining a higher inflation target, or even directly controlling currency to have negative nominal rates through the use of Central Bank Digital Currencies.

Such developments seem like an active effort to disincentivize savings broadly. Savings rates show that the unprecedented liquidity provided in the wake of COVID simply passed through consumers’ hands on their way to their ultimate destination on corporate balance sheets. Without a healthy public market for equity ownership, money creation is laundered through the hands of the public to a shrinking cohort of modern oligarchs.

Public markets are one of our greatest tools to combat inequality. Modern social justice parlance focuses intently on “equity” sometimes losing sight of the fact that it quite explicitly means ownership. Many policies, such as qualified retirement accounts and 401(k)s, encourage public equity participation from investors, but public markets need to regain their luster as a superior form of financing. Large employers, beyond the technology industry, should view share-based compensation as a tangible and meaningful way to attract, retain and reward talent throughout their organizations.

Problems of inequality, posturing around ESG standards, or debates about corporate taxation can be at least partially assuaged by greater public equity ownership. As certain forms of wealth creation like home ownership, small business, or even ascent through a corporate hierarchy, seem further out of reach, public equity markets remain a solution hiding-in-plain sight. More companies with real earnings and cash generation finding their way to public markets where their growth and governance can be more broadly distributed is a market-based solution already within our grasp.

We must examine the system on which these great masses of money are manipulated, and assure ourselves that it is safe and right.

- Walter Bagehot

The subtext, and occasionally the denotation, of discussions about finance is a shared idea of properly functioning markets. Our beliefs about “the way things are supposed to work” are part of the tapestry of confidence and understanding that facilitate trade. These choices, beliefs, and structures, broadly our political economy, have for over 30 years been taken for granted. Daniel Peris writes, “Our financial institutions rely on our political structures, and our political framework works because of certain underlying economic relationships. Separating the two realms is impossible.”

Despite this plain truth many who occupy roles in finance, either through ignorance or conscious effort, refrain from critique or examination of these core assumptions.

Finance professionals and politicians tend to “stay in their lane” and thus poorly understand how the highway system works. Moreover, most individuals within a political economy mode naturally assume it will continue in perpetuity. While modes can last for many years, decades or even centuries, they can and do change. We’re in the process of one of those changes1.

Fukuyama, Graeber, Hochuli, and others have well documented the “End of History” in the sociopolitical sense, but our conceptions about the role of finance and by extension our relationship with time itself are also undergoing seismic shifts.

Yale economist Robert Shiller describes finance as a collection of mechanisms for “moving money through time.” Savers need today’s dollars in the future, borrowers need future dollars today, and the institution of credit links the two. A generation prior another Yale economist, Irving Fisher, said “Interest is, as it were, human impatience crystallized into a market rate.” In very real ways our present is funded by castles in the sky, by the world we will be delivered into in the future. Perry Merhling writes in The New Lombard Street,

The web of interlocking debt commitments, each one a more or less rash promise about an uncertain future, is like a bridge that we collectively spin out into the unknown future toward shores not yet visible.

Time and Money

Keynes famously coined “Animal Spirits,” our unquantifiable urge to action. It is an expression of our individual attitudes about the future, and capitalism is our collective action to shape it.

Two timelines emerge from this desire to shape the future: Economic and financial time. Economic time deals with the present reality of acquiring resources and creating assets, while financial time ticks along discounting value that will be delivered in an unknowable future. In the height of COVID-19 lockdowns, Larry Summers said "Economic time has been stopped but financial time has not been stopped.” Money and finance accompany our economic lives to help us cope with the “experience of being caught between an unchangeable past and a wide-open future.2”

In the preceding three decades, this future seemed to have a gravitational pull. Technological progress accelerated and created ever-cheaper consumer products that improved our lives but also dulled the more acute symptoms of inequality. Growth and (somewhat) shared prosperity were a runaway train. Bruno Maçães writing in Foreign Policy, again amidst COVID lockdowns,

Modern Western societies like to think of themselves as being part of the accelerating movement of history—progress broadly understood. Too often, however, the feeling in these societies is that we have lost control over all the movement or agitation taking place around us: The economy has its own logic and should be left to its own processes. Society has a predetermined direction, one we can applaud but not shape. The winning values have been determined, and our task is merely to realize them. Being on the path of progress felt like being driven by forces beyond our control. Stopping or pausing was something no one would dare to imagine, even as it comprised the indispensable first step of a society deciding its own future. That the historical clock could stop—in whatever form—seemed an impossibility.

Since the turn of the century, the veil of coherence on our prevailing political economy has slipped too many times. The GFC threatened a fatal blow, but the dramatic coda of COVID finally woke us from the belief that the shores of the future were manifest and that the logic of the economy was beyond our grasp. We learned through visceral experience that when it comes to time, the meantime is all there really is. Carlo Rovelli, an Italian physicist, in his fantastic book The Order of Time writes,

Because everything that begins must end. What causes us to suffer is not in the past or the future: it is here, now, in our memory, in our expectations. We long for timelessness, we endure the passing of time: we suffer time.

This is a problem for economics. Economic and financial time is an “and never the twain shall meet” situation. Keynes was dismissive of the long run, “we are all dead in the long run,” and derided what he called “the fetish of liquidity.” But this does not reflect our reality. Political economist Martijn Konings,

The structure of the capitalist economy is a temporal one — not just in the trivial sense that things take place in time and are therefore subject to change, but in the more profound sense that time is an active force and that it, therefore, makes no sense to analyze processes of change as if they are driving toward a neutral state where things are organized according to their true value or purpose…[Hyman] Minsky did not have much use for the idea of such an independently given long run: in the economic game of capitalism, some survive and others die, some thrive and others languish. In that sense, there really only is the meantime — all time was -borrowed.

The degradation of financial time expresses itself in fatalism among market participants. Positioning one's self for the next speculative bubble or maintaining just enough liquidity until the inevitable bailout supersedes discounting future outcomes. Financial and economic time collapse into a single timeline disrupting the institution of credit. Perhaps most disorienting, policymakers lack the tools to intervene because they don’t regard the current environment as a possible system state.

Money and Political Economy

The degradation of financial time is challenging to identify and its impact on our political economy impossible to predict. As others have noted, much of our zealous partisanship is nothing more than a release valve for the frustration of lacking agency in shaping the future. Michael Cuenco and Blake Smith write,

In this senescent neoliberal moment, the powerlessness of the state trickles down into an analogous sense of powerlessness among individuals. Politics invites them to convert their frustrations into fuel for the culture war—the intensity of which is matched only by its inefficacy as a means for catalyzing material change. As if the empty moralism that motivates the toppling of statues or the cheap thrill of “owning the libs” is meant to compensate for the collapse of the middle class or the cratering of economic opportunity for anyone under forty.

The role of money and finance is no less a battleground. Conspiratorial thinking surrounds the machinations of central banking and Potemkin revolutions like cryptocurrency stunt the development of new models grounded in realism. An inability to grapple with our economic preponderance generates little in the way of substantive policy solutions. We may have wrested control of the runaway train, but we are nonetheless terrified of a derailment. The question for finance is the role and inherent instability of credit. Institutions attempt to tune the market towards stability, but our inability to predict the future means that the distinction between speculative and productive credit can only be known ex-post. Merhling, again in The New Lombard Street,

In any concrete case, the question therefore arises, Are we looking at a Hawtreyan speculative bubble that we want to rein in, or at Schumpeterian dynamic growth that we want to let run? One reason this question is hard to answer is that a credit-fuelled boom typically involves a bit of both.

There are no monetary solutions to the problem of a future too deeply discounted. Central bank policy transmission is faltering as fatalism tightens its grip on markets. “The seductive allure of present credit, and the crushing burden of future debt, are two faces of the same creature.3” As we lose fidelity on the future, our appetite for present credit proves too tempting, even rational. The time machine of finance ceases to function.

Only a true political paradigm shift will break us free from this malaise. A new political economy must reinvigorate the malleability of the future so that financial and economic time can again diverge. Neither a technocratically administered utopia nor the further liberation of market forces achieves this aim. Our institutions and markets must support our will and capacity to dictate our own fate in ways they currently do not. “Animal spirits” do not rely on an innate desire for self-reliance so much as a belief that our actions help shape the future in ways that will persist beyond our own time. Returning finally to Carlo Rovelli’s Order of Time,

“We understand the world in its becoming, not in its being.”

Cash, short of burning it, which creates fiduciary risk, cannot be created or destroyed.

- Mike Green

Pity thee who disagrees with Cliff Asness on the internet but the concept of “money on the sidelines” continues to be widely misunderstood. It seems that a key source of the aphorism is a fun article Asness published in the Financial Analyst Journal in 2014 titled “My Top 10 Peeves.” It is a study of market colloquialisms, heuristics, and myths that Asness takes to task with his trademark efficiency and wit. Number 5, a collection of common phrases, includes “It’s a stock pickers market,” “arbitrage,” and “There’s a lot of cash on the sidelines” that Asness wishes were permanently retired.

Every time someone says, “There is a lot of cash on the sidelines,” a tiny part of my soul dies. There are no sidelines. Those saying this seem to envision a seller of stocks moving her money to cash and awaiting a chance to return. But they always ignore that this seller sold to somebody, who presumably moved a precisely equal amount of cash off the sidelines.

If you want to save those who say this, I can think of two ways. First, they really just mean that sentiment is negative but people are waiting to buy. If sentiment turns, it won’t move any cash off the sidelines because, again, that just can’t happen, but it can mean prices will rise because more people will be trying to get off the nonexistent sidelines than on. Second, over the long term, there really are sidelines in the sense that new shares can be created or destroyed (net issuance), and that may well be a function of investor sentiment.1

But even though I’ve thrown people who use this phrase a lifeline, I believe that they really do think there are sidelines. There aren’t. Like any equilibrium concept (a powerful way of thinking that is amazingly underused), there can be a sideline for any subset of investors, but someone else has to be doing the opposite. Add us all up and there are no sidelines.

What seems most at issue here is a variety of semantic distinctions that are not entirely trivial. Of course, Asness is right at the very practical level that the units of exchange in every trade are equivalent, but I don’t believe those that refer to the overall level of cash allocations are suggesting otherwise. Similarly, Asness’ first “lifeline,” that they are referring to sentiment, also seems to miss the implication of an aggregate change in demand for risk assets. Liquidity needs and time horizons can impact the relative risk appetite of investors as much or more than their bullishness on equity prices. His second lifeline, the creation or destruction of financial assets is actually crucially important. What if the supply of financial assets is structurally low and sticky— in economics parlance, “supply inelastic?”

Stocks and Flows: the Inelastic Market Hypothesis

The issue at hand is that many refer to a “stock,” the amount of cash in money markets/cash equivalents to make an inference about the impact of a “flow,” a rate of change, movement, or activity. The flow portion is the critical element of investors, in aggregate, shifting their demand to risk assets. In a more academic understanding of the market, investors are making assumptions about fundamental value when they transact, and those fundamental assumptions are reflected in asset prices. While asset prices are noisy over short time frames, and many models account for liquidity in a micro sense, there is a core belief that stock price movements are reflective of investors’ shifting attitudes toward the future (the net present value of cash flows).

Xavier Gabaix & Ralph S. J. Koijen introduce an important alternative to this assumption in their June 2021 paper “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis.” According to the hypothesis, financial market fluctuations occur mainly because the supply of financial assets is relatively inelastic, meaning it does not quickly adjust to changes in demand. In other words, when there is a sudden increase or decrease in demand for assets, the market cannot instantly create or eliminate these assets to match the new demand, leading to price changes.

We start by asking a simple question: when an investor sells $1 worth of bonds and buys $1 worth of stocks, what happens to the valuation of the aggregate stock market? In the simplest “efficient markets” model, the price is the present value of future dividends, so the valuation of the aggregate market should not change. However, we find both theoretically and empirically, using an instrumental variables strategy, that the market’s aggregate value goes up by about $5 (our estimates are between $3 and $8, and we will use $5 for simplicity in the theory and discussion). Hence, the stock market in this simple model is a very reactive economic machine, which turns an additional $1 of investment into an increase of $5 in aggregate market valuations.

This is admittedly obtuse to understand in a theoretical or general sense, but when viewed in the context of the rise of passive investing, it becomes clear that while a “stock bought” may indeed be a stock sold, the clearing price of that transaction is subject to a previously unconsidered constraint.

Mike Green’s Ode to a Burning Urn of Cash

No one has been more vocal in calling into question the impact of passive investing than Mike Green of Simplify Asset Management. I briefly covered some of Green’s views in Like A Pro:

Prices are a little bit like Schrodinger’s cat, they tell you where something was on the last transaction, but they don’t actually tell you what the price is, right? The price could be up, it could be down. We don’t know that until the next transaction occurs. Passive is assuming that they’re not having any influence on that next price but they have to be because they are transacting

On his Substack2, Green has done a great job of illustrating, in more practical terms the impact of a dollar moving from cash to the market. Green does so in the context of funds shifting from active vehicles, which hold more cash (~5%), to index vehicles which hold almost none (17bps), but the impacts of leaving money markets to re-enter the market are nearly identical.

The statement that is obviously on the lips of skeptics, “OK, so active managers average 5% cash, and passive managers only hold 17bps of cash. Big deal. Markets go up 5%.

This is a misunderstanding and sits at the core of the problem. Cash, short of burning it, which creates fiduciary risk, cannot be created or destroyed. If active managers are redeemed and replaced with passive managers who want to hold less cash, the ONLY solution is for equity prices to rise.

Why? Green has an excellent illustration, but as dollars move over to passive, the passive fund needs to find a market of sellers to get back to their target cash level.

Note that it’s not a solution to have active managers sell $9.50 AND passive managers buy $9.99. That is not a transaction, as buying does not equal selling. To arrive at a solution, we must solve iteratively for where buyers are equal to sellers. As a result, equities appreciate by more than 1% for a 1% allocation to passive.

Beyond our traditional understanding of liquidity, dollars entering the market are increasingly finding an absence of discretionary sellers. These impacts are still in their early phase, as Green points out, passive represents a sizable (45%) but not yet a majority of market assets.

So, is a share bought a share sold? Yes, but the transaction is not as simple as the academicized exchange described by Asness and others. The discussion itself reflects a common challenge in finance discourse wherein the realism of market structures and incentives runs increasingly counter to theoretical notions of value. The inverse also holds. Aside from a logical hypothesis on the impact of passive market actors, can their impact be empirically proven? Massive one-day changes in the value of the largest companies in the index seem to be at least indicative of something new occurring.

While Gabaix & Koijen focus on the supply side of financial assets, another group of researchers at UCLA identified that demand too is inelastic, leading to a decrease in overall market efficiency. Simply put, “not enough people are showing up to trade. You have less information in the market, less aggressive trading, less accurate prices and a more volatile market.” In such an environment, with growing cash balances, a potential reversal obviously has price impacts that go well beyond what can be explained by “sentiment.” The philosophical or practical existence of sidelines, or of people proverbially leaving them, is shorthand for a broader shift in risk appetite hitting an equity market with increasingly less capacity to meet the demand.

This weekend saw the release of the annual Berkshire Hathaway Annual Report and Chairman’s Letter. With it were the usual shows of piety and equally rehashed criticisms. There was also, however, a new, palatable sense that while Buffett’s strictures were no less relevant, investors are finding them less nourishing. I do not believe this feeling is unique to Buffett acolytes. Despite a proliferation of financial content in the form of newsletters, substacks, and podcasts, there has not been any uniquely new, or refreshingly bold, thought on the inherent problem of investing. Even this publication which seeks to be “a public journal of my notes on the best investment writing I find from the past and today” is significantly weighted to the past relative to today.

Graham, Dodd, Buffett, Munger, Marks, Greenblatt, Klarman, et al. are a generation (or two) removed from the people actually doing the bulk of investing today. Perhaps it is anathema to value investors to even believe there should be pioneering ideas around investing. It could be that there simply isn’t much more philosophically to add to the canon. Even with the benefit of experience and various academic breakthroughs, valuing companies and constructing portfolios remains in an elusive chasm between art and science.

It is also conceivable that the Money Game has simply gotten too disambiguated to be talked about practically. The proliferation of highly quantitative strategies and the academic obsession with pounding markets into the laws of nature have made more subjective inquiry seem quaint bordering on naive. Still, markets interact with society and political economy and their diversion from the economics of everyday life tends to converge violently and frequently enough to warrant discussion.

It seems unlikely that in the face of accelerating technological, social, and political change that investing or even the role of finance in society should not warrant new degrees of enlightenment. Of course, there are talented writers that are synthesizing the present and making sense of financial developments, but few seem to be focused on expelling dated notions or building new frameworks. Dialogs about investing are caught in a loop between ex-ante theorizing and ex-post quarterbacking.

To have a substantive discussion you must abstract to a hypothetical level better left to academia. If I ask, “Would you invest 100% of your capital in a risk-free investment that provided 8% per year?” we can address a number of considerations dispassionately, but when I ask a similar question about a security in the market, the conversation succumbs to the weight of the million logical fallacies and biases that befall investors every day. Perhaps this is why Buffett and the other practitioner-philosophers of investing are so fond of talking in parables and aphorisms. After six decades of Berkshire letters, still, only a precious few have any idea how investment decisions at the company are actually made.

Macro palm-reading, repackaged sell-side reports, and “Bear Porn” dominate the self-published landscape. While professional writers typically produce a higher quality product, they too are bound by the business model of hyper-timeliness and reductive brevity1. As Keynes famously wrote, the work of investing is “intolerably boring and over-exacting,” so it is no surprise that the market for exploring it with any depth is limited.

Buffett has enviably attracted not just a long-term investor base but an audience that eagerly awaits 5,000-word tomes about “buying companies, not stocks.” He has also spawned a generation of money managers and commentators that aim to talk like Buffett but almost always end up repeating him. When Issac Newton spoke of standing on the shoulders of giants, surely he didn’t literally mean just to enjoy the view.