It’s time to face up to the following reality, people: as a vehicle for generating material, sustainable investment returns, the liquid markets are something of a wasteland. This may not always be the case, but as of now, if you shove a mirror under their nose, very little fog will materialize.
There are many reasons for this. Telecommunications advances have removed whatever information advantages that government agencies haven’t already regulated away. Hundreds of thousands of trained professionals stare at Bloomberg terminals all day long, combing through voluminous information sets and ready to pounce on any pricing anomaly. Investment platforms with more money than Croesus infiltrate every aspect of human activity with a bearing on financial pricing, all in search of a minute edge. Billions of dollars are being spent on data collection and analysis each year, of a scale unimaginable even a few years ago — and this process is on a hyperbolic trajectory. All of it is designed to capture microscopic mispricing opportunities in stocks, bonds, commodities and foreign exchange.
Against this backdrop, what idiosyncratic advantage does anyone have, say, in buying a few shares of Google? Or selling dollar-yen? Even more pertinently, why would anyone rationally pay someone else a two percent management fee and sacrifice 20 percent of performance — the hedge fund model — to make these trades for them?
As someone who has enjoyed a 30-year career analyzing liquid market investments, these are painful assertions for me to convey. But sooner or later, we have to face the truth: there is more juice in privately held financial investments than in liquid securities. But here, too, the standard model is flawed as most mere mortals do not have access to private investment markets; instead the sweet fruits on this tree are reserved for the select few. Even then, access mostly derives from private equity fund enterprises, which operate under a model that virtually ensures these entities will buy and sell their assets in a manner inconsistent with the objective of fully harvesting the value of these investments.
Private equity funds are, by design, inefficient value conversion engines. Their structure only allows them to charge management fees on investedcapital. Thus, when you hear that a fund has raised $1 billion, it is typically under a construct where investors simply make a commitment to finance the portfolio at the time such financing is needed. When a deal emerges, the fund notifies them of how much of their commitment is required to complete the transaction. It is only at this point, on these deployed amounts, that the fund is able to charge management fees. As such, there is a structural incentive for private equity funds to invest their committed capital as expeditiously as possible, so as to maximize the management fee they charge. In consequence, they often invest too early in the life cycle of a business enterprise.
A similar inefficiency applies to their performance fee revenue stream. Because this portion of the fee structure only applies upon the liquidation/monetization of a given investment, there is an embedded incentive to sell assets at what may otherwise be considered a suboptimal point for doing so. In any event, the full benefit of compounded investment returns that are the objective of business enterprises seldom flow in full measure to private equity fund investors.
So how can an investor hope to achieve even reasonable return objectives under these circumstances? Well, the answer was supplied to us several decades ago, by — who else? Warren Buffet. His approach calls for the acquisition of economic assets under a long-term, owner/operator construct. He only invests when he thinks he can buy a revenue engine/earnings stream at an appropriate price, and when he does buy, he does so under the assumption that he will harvest this revenue stream into perpetuity. As a result, both his entry and exit points are those of his own choosing. Particularly over long periods of time, the compounded returns associated with this approach positively dwarf those of any relevant index or fund product.
I present this case at a particularly pertinent pass in the affairs of the global capital economy. It is a fact that the world’s infrastructure upgrade needs have rarely been more glaring — these needs take the form of climate management, environmental controls, improving the global electric grid, the growing shortage of vital resources such as clean air and water, and a host of others too numerous to name in this space.
Historically, and today, responsibility for managing these challenges has been almost unilaterally devolved to governments, as funded through a combination of taxation and debt. The economics behind this approach are well-established: these issues are ones where the benefits and costs fall in relatively even fashion across entire populations, with no individual economic entity overly incentivized to address them. Collective problems call for collective solutions, and this, at least historically, has been what government is all about.
But government indebtedness has reached alarming levels, and its incremental ability to address this ever-growing set of challenges has never (or rarely ever) been more financially constrained. Contemporaneously, private sector resources are at a historical high — all in a world where, in part due to slowing global growth, opportunities for reinvestment in their own business lines are, at best, finite. Similarly, investors — most of whom have benefitted significantly from a decade-long recovery (in a world where the lion’s share of real interest rates are zero or negative) — are faced with a diminished set of capital redeployment alternatives.
The solution, as I see it, is to apply an ownership model, a la Berkshire Hathaway, funded by the cash-rich private sector, to convert critical structural challenges into revenue opportunities. Examples of favorable openings in these areas abound. Across the globe, there are innumerable harbors in need of dredging. Many segments of the agricultural, mining and manufacturing sectors are actually paying to remove waste from their production processes, rather than, as is entirely feasible, repurposing these unused materials for the manufacture of other value added goods. One illustration of this — the removal of fly ash in the processing of coal — is currently an enormous expense to the industry, and a material environmental problem for society. Fly ash, as it happens, is a useful material for the production of intermediate products — ranging from cement to various forms of ceramics. Thus, right before our very eyes are opportunities not only to add efficiency and remove waste from a production process, but does so in a way that benefits the environment and creates lucrative profit streams along the way.
The ownership/operating company model is ideally suited to this construct, and the time to attack our vexing challenges, by turning them into enormous business opportunities, has indeed arrived.
And for me, the path forward is clear. I have made arrangements to redeem some liquid market investments, in order to allocate capital to a company called DIATOMS — which adopting the exact model described above. It is already well under way in a process of applying an ownership model to infrastructure issues. If it is successful, DIATOMS will create value in the areas and communities with which it is working, and its opportunity is only limited by the scale it can achieve. But here’s the good news: there’s a virtually-unlimited amount of important projects to which it can bring its methodology to bear — for the benefit of all.
So I’m voting with my feet on this one, and feel very good about the prospects of scalable return. But readers of course are at liberty to decide these matters for themselves. They can certainly buy a few more shares of Google, or to pay someone to perform this function on their behalf. However, with three decades of experience as a risk manager, I think the data suggests that there’s a better way forward.
Ken Grant is the Founder of General Risk Advisors, LLC. Prior to GRA, Ken founded ConceptONE (previously known as Risk Resources) a risk management outsourcing business, catering to trading/alternative investment business, which provides risk consulting, product development, capital introduction and related services to these group. Ken has also served as the Head of Global Risk Management for Cheyne Capital, the Managing Director Risk at SAC Capital Advisors and the Director of Risk Management at Tudor Investment Corporation. Ken is a Faculty Member at Columbia University focused on Risk Management/Actuarial Sciences and is a Fellow at the Center for the Management of Systematic Risk at Columbia University. He is the author of “Trading Risk: Enhanced Profitability through Risk Control” (Wiley ’04), Risk Management Curriculum CFA (CFA Institute, ’05) and was the principal author of “Sound Practices for Hedge Fund Managers” (Managed Funds Association, ’00, ’03, ‘05). Mr. Grant has an MBA from the University of Chicago, a Master in Economics from Columbia University and a BS in Mathematics from the University of Wisconsin.
He is an advisor to and investor in Diatoms.