When will Private Equity and Real Estate return to innocence?

Not too long ago I wrote about the merits of relative-value strategies in a world dominated by diminishing returns and rampant inflation. This is a follow-up, touching on one of the interpretations of relative-value strategies and the repercussions it would likely create.

The folks in Private Equity and Real Estate understood long ago that you make money with “other people’s money”. The game is simple: Find an asset that produces a certain annual return X and then finance the acquisition at less than X pocketing the difference. The trick requires 2 elements:

• An asset with a stable and reliable source of income, ideally protected from inflationary pressures that can continue long into the future, and

• A reliable source of financing with fixed payments for a period matching the duration of the strategy.

Add the tax shield on the interest payments and one can see the juicy appeal of the strategy and why it has been employed globally… on a massive scale, by everyone... big and small - after all, the liquidity created by the central banks has to go somewhere. In conjunction with low interest rates it created the “jungle-juice” concoction that led to astronomical valuations, in pretty much every asset class known to man - “The Everything Bubble”.

It should come as no surprise, especially considering the fervor behind the money entering public markets alone, giving birth to the "To the Moon 🚀 " movement. If crypto investors went to the Moon and equity investors followed Elon even further towards Mars, it’s fairly safe to say that as I am writing this that real estate investors and PE investors are already past the moons of Jupiter.

A simple example may illustrate the point better. Say you are a PE looking for an acquisition and find a sleepy grocery store generating a mediocre 4% Return on Assets every year, the salivary glands may be already kicking into overdrive. Years ago everyone would have likely balked at this sort of investment opportunity but given the availability of ample supplies of cheap money, the PE vultures are not only circling but fighting over our sleepy grocery store. Indeed, a pitchbook will be put together in a hurry showing how the grocery store will be transformed by data analytics, ecommerce and AI while projections of +15% CAGR (compound annual growth rate) will be the pessimistic scenario for this disruptive enterprise. This ensures obtaining financing at below 3% for 10 years, while published inflation is running wild at +7%. If one can further make the case that the produce sold is responsibly sourced and farmed sustainably in a way that captures CO2, the cost of borrowing comes down even further.

John Lennon said that: “A dream you dream alone is only a dream. A dream you dream together is reality”. While you ponder the deep implications of this cognition, bankers, PE investors, lawyers and accountants are hard at work building the dream, knowing full well that their commissions will be paid Today with real money and that somebody else will be left with the dream in exchange.

At this point I should qualify things further and explain that imagination is a key component of every worthy endeavour. It is the seed that leads to every human accomplishment and a collective dream can move mountains. Unfortunately in this particular case, the clever bankers GMO’ed the seed stripping it of all its nutrients leaving behind something that will grow into a tasteless vegetable that unfortunately some will have no choice but to eat given the lack of alternatives.

Excess is nothing new in financial markets. They seem to go hand in hand - nobody wants to go home from the party when they are having so much fun and making so much money. Never enough.

So what are the implications:

• Wealth and productive assets will continue to concentrate in the hands of the few that can be selective and access the best investment options, along with the cheapest financing, which as we are already witnessing has deep economic, political and societal implications.

• A time will come when PE investors will wake up from the dream and face reality. When asset returns exceed the growth in productivity for extended periods, the result tends to be a resounding disaster, for investors and economy participants alike.

• The recovery will be long and painful, especially for little investors who got bamboozled by their advisors. If we are to have a chance at making the world a better place, society needs to stray away from the Casino aspects towards wholesome, good old fashioned values - such as hard work, saving and good morals - things that the “get rich quick” (or die trying) mantra of the influencer generation has stripped from us.