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Private equity faces a challenge that may be inherent in its business model, said Howard Marks, ’69, chairman of Oaktree Capital Management.
To make money, investing should be done anti-cyclically, which means buying low and selling high. But leverage, which private equity funds largely rely on, fluctuates pro-cyclically, becoming more readily available at the high point of an economic cycle and less available at the low point, he said.
Marks shared insights during a keynote address at the ninth annual Beecken Petty O’Keefe & Company Private Equity Conference February 19 at the Hyatt Regency in Chicago. Sponsored by the Polsky Center for Entrepreneurship and the student-led Entrepreneurship, Venture Capital & Private Equity Group, the event included panel discussions on numerous aspects of private equity, such as investing in infrastructure.
“The ten largest private equity funds in the world invested $120 billion in the year that ended August 2007, which arguably was the top.” Marks said, “And in the year that began with the bankruptcy of Lehman Brothers in September 2008, which arguably was the bottom, they invested $9 billion. So they invested thirteen times more at the top than at the bottom. That is pro-cyclical. Why did they do that? They did that because their business model was based on borrowed money.”
Marks said private equity should “return to its roots” of buying cheap and adding value, “not counting on leverage as being a free lunch, and not assuming that it will be able to sell dear. If it does that, I think it will be successful.”
In trying to buy cheap, he said, it’s important to take the temperature of the market and to be skeptical. Investors need to know when to say “things can’t be that good” and also when to say “things can’t be that bad.”
He said asset bubbles occur when “people seize on a nugget of fundamental truth and forget to say, ‘But at what price?’” The nugget of truth that led to the tech bubble in 1999 was that the Internet would change the world. The one that led to the housing bubble in 2007 was that real estate keeps up with inflation.
When Marks’s son, also an investor, lays out a case, Marks said he will say to him, “‘And who doesn’t know that?’ That is really the critical question in investing.”
Most people agree that China is going to grow faster than the United States and will become an economic powerhouse within this century, Marks said. “And so the logical conclusion is that you should invest in China.” But “if you believe in efficient markets,” then all that’s good about China may already be taken into account in prices. “So by buying Chinese investments today, you’re not really doing anything special if you’re paying a price that fully reflects the merits of investing in China.”
Investors should look at buying assets that everybody else says not to buy, because those are usually the assets that can be bought the cheapest, he said. Today that means illiquid investments like private equity, distressed debt, natural resources, venture capital, and, down the line, real estate, Marks said.
Michael Duffy, first-year student in the Full-Time MBA Program, said he agreed with a lot of what Marks said about counter-cyclicality. Marks “touched on the human psychology of the comfort with the herd,” and the tendency to believe in the fallacy that the higher the price of an investment, the more it is worth. “The psychology is incredibly important in market extremes,” Duffy said.
—Mary Sue Penn