Good morning everyone, welcome to the final day of FII and a particularly exciting chat about capital allocation. I'm told this is very much the investor day, so I hope you're here for some brilliant insights from our panel. Let me introduce you: we have Zoe Cruz, the founder and CEO of Menai Financial Group; we have Josh Harris, founder of 26 North; Jeffrey Jaensubhak, who's the group CIO of GIC; Dan Morehead, founder and managing partner of Pantera Capital; George Walker, chairman and CEO of Neuberger Berman; and finally at the very end, Anne Walsh, managing partner and CIO of Guggenheim Partners. Now we're going to be talking about alternative investment, which is clearly a huge market, over 20 trillion, still growing. But is the easy money era over? And I'm certainly hearing concerns in the hallways of FII and behind the stage about the size and sustainability of some of the asset classes. I'd like to start with you, Anne. Why don't you lay out for us how the alternative markets area is performing so far this year and what are your expectations going ahead?
So I think the strength of the alternative markets is evident and I'm very optimistic for the future. We have to define alternatives at the outset, which is it's a very large and expanding market, maybe just beyond the public markets for bonds, stocks, and of course cash, of which there's trillions of dollars sitting on the sidelines ready to be deployed into all sorts of opportunities. So I think year-to-date we've seen good results. I think we were going and we are going to continue to see that in the future. If I think about the macro backdrop a bit, I think the opportunity is definitely there to take advantage of the ever-increasing size of the private capital markets as we see the shift from public markets more to private, from traditional bank lenders to the private markets. And that includes private equity, private credit, private asset-backed lending, and the like. And so I think we're going to continue to see this expansion as we see this migration of capital, and this is happening not just in the US but also quite strongly globally as well.
Josh, how much of the performance do you think is tied to macroeconomics?
Yeah, look, I think it's much less than other asset classes. I mean, obviously what you're doing is you're trying to—I mean, macro obviously affects everything. In a big downdraft you get dragged down, in the big updraft you get dragged up. But to a large extent, you're holding for longer. The whole point of alternatives is they're less liquid and they're more absolute return driven, so you can kind of wade through environments and create value by fundamentally making investments that you sustain for a longer term. And so I think that while everything is driven by macro, obviously alternatives probably has a little bit more staying power through macro. And so I think what's happening is that certainly alternatives, private assets are outperforming public assets and so you're going to continue to see them expand. But on the other hand, I do think that the party is a bit over. Since for the last 15 years every time you bought something, interest rates went down and it was worth more than it was the day before, so people kind of got used to that, they lost their discipline. And the lower interest rates carried everyone up, which is the macro obviously. And now what we're seeing in the last few years obviously is a stabilization and uptick in interest rates. That's going to make it kind of back to where we all started, which is you got to make money the harder way. You've got to buy well, you've got to help the companies or the investments, and then you've got to sell well. And so I think that the fundamentals are shifting. There's also a lot more capital. You've got people in this region, other regions, it's globalized. You even got the retail investor coming in. So all of a sudden you've got a lot of supply of capital. So we could talk a lot about it, but I think that the party is a bit over. But you know, it's like everything else, there'll be a shakeout, there'll be an industry structure shift, and then the good alternatives firms will get better and the ones that are probably less good will be gone. So that's probably healthy for the industry.
I feel like that was the first warning shot fired. Zoe, is the party over?
I don't know, but I made my career dealing in probabilities, probabilistically derived outcomes. So I kind of step back and look at on a scale of 1 to 10, is the party over? Are we at 10? I am a believer that there will be opportunities. I agree with Josh, but how big the downdraft is going to be is—I think we're maybe at 7, 7 and a half. The asymmetry of risk reward, which is to actually get that additional return, you're going to need to take increasingly more risk. And the reason I feel unequivocally strongly about that is when I joined Morgan Stanley in the early 80s, and what made my career is overnight rates were 21% on their way to zero, and 30-year treasuries, risk-free rate of return was 15% on their way to 2. So 60/40, 40/60, didn't matter. That party is over. So since all of us are looking at risk-adjusted returns, I would believe in the traditional asset classes we're not getting paid enough for the risks we're taking. It's a very big, broad statement, but I think this quest for risk—we're not looking enough at risk-adjusted returns. I believe the opportunities are enormous and a lot of people talked here in the last few days about the huge opportunities. I agree, but in my career, which spans many, many years, I've never seen—and I use the word 'never' very sparingly—the fat tail risk being as fat as it is. Who agrees with that?
And Jeffrey, we haven't heard from you.
Yeah, I think Zoe pointed out something that is really apparent to all of us, which is that there's heightened uncertainty in the world around politics, geopolitics, technology, even climate change. But a lot of assets are priced at the highest valuations as if that uncertainty didn't exist and as if it didn't matter. And I think if there's any lesson that we get from high valuations is that when the catalyst comes, the drop can be very high or very tall. And so I think that's a risk, the fat tail risks out there that in probability terms, I think in terms of actual potential losses, are also there. I think that means that for allocators, you have to be especially careful, whether as a GP choosing between companies you're investing in or as an allocator across asset classes, you have to construct your portfolio well to be able to take some of that potential volatility.
The chat I've been having frequently appears in the speakers lounge in the halls of FII is about something called private credit. George, explain it to us in simple terms what private credit is and why there's been such big growth here.
Private credit is a whole series of different strategies. Often you read about it in the press as called shadow banking. I think the way that most folks have started investing in private credit was originally providing senior loans to sponsors, which have produced terrific returns for folks over time. And now the definition of private credit has expanded significantly. So what was first corporate credit, now is really turning and pivoting towards asset-based credit. And folks are finding that they're able to earn far higher returns than in public credit markets by accessing these loans directly as opposed to participating in public markets. And it's becoming a challenge, frankly, also for—you've seen a lot of banks talking about this as being problematic—is the role of the bank. A lot of these loans historically were on the bank's balance sheets, and now we are putting them on the balance sheets of GIC and retail investors and other places, which I would argue in a broad sense is probably good for the world that these sorts of loans are on the balance sheets of very long-term investors and not sort of levered, guaranteed financial institutions.
Yes, so the growth in private credit—obviously private credit, private equity, private assets—the reason that they've grown so much is that they've traditionally beaten the public markets on a risk-adjusted return basis. There's been a trade of liquidity for return. Obviously as all this money flows in, right, it gets a little bit harder. It's not as easy. But truthfully, private credit, as George is saying, continues to be the best place to hide in a really somewhat overvalued fixed income market. You can probably achieve 300 plus basis points of excess return per unit of risk in certain strategies, and that's attractive for a portion of your portfolio which is not liquid and you don't need to necessarily—there's also some question we could debate for a while, how liquid are the public markets? That's sort of a whole other existential question and are they really that much more liquid than the private markets? So there's all these things, but by and large, almost all private assets now are more competitive than they were, but they're still probably better than the public markets generally.
And there's probably less regulation, which I'll come on to. But first of all, our AI avatar did weigh in on the subject of private credit and obviously we'd all love to hear from her or him—I forget if it's Sha or Safiya. It's Sha. Sha, take it away.
Good morning everyone. Let me add my view: private credit's $2.1 trillion market may be a ticking time bomb with 20% covenant-light deals and one-third of borrowers struggling with interest costs. We may actually be blindly racing towards another 2008-style meltdown.
Never one to mince words. Anne, ticking time bomb?
So we've mentioned the fat tail risks and I think that's true because there's a lot of crosscurrents. For those of us who are US investors, particularly in fixed income, we've seen the end of the bull market in bonds in the US. This tends to usher in a period of time for other types of investments to take more center stage, and one of those areas is credit. If I look at two—to oversimplify—two risks that I tend to look at together as being the ones that when they work together in the worst possible way tend to create the market seizure moments, and that is a lack of liquidity and leverage. And usually when those are taken together, a high risk that is leveraged, that's a significant problem. But right now we don't see that because there's a lot of liquidity in the system. And as I mentioned, there's six trillion dollars sitting on the sidelines in cash in the US, for example, and there's a lot of money that's still being deployed globally that's available to make investments. So I really don't see those two elements coming together at this time or frankly in any kind of time frame in the near future. And the $2 trillion that's gone into private credit is really just sort of migrating from banks. So it's not like we've really increased the total amount outstanding in private lending, it's just we've shifted the holders from banks, traditional investors, and moved it into the hands of other institutional credit providers. So I tend to think of these not as the risks that I'm really focused on at this moment, but there are a lot of crosscurrents and there's certainly a macro backdrop right now of investment deployed into new areas, whether that's sustainable energy or artificial intelligence—case point, our guest speaker—and any number of other investments including population shifts and the like that are happening right now, reshoring. And those are creating opportunities for private credit investors.
At the same time, you have beautifully—I just would add, we manage about $30 billion in sort of eight different flavors of private credit. By and large, the investors, if you had to group them into two types, one would be large institutions. They're often taking their exposure down in public equities and allocating to private credit, and that private credit is often without leverage or with very low leverage. So that's inherently de-risking the system. Both that investor is taking less risk moving from equities to credit, and it's taking it out of a concentrated, levered, government-guaranteed banking system. The other place is with retail investors, and again typically with very low leverage. What I do think we're going to find, to Josh's point, is the area has grown quickly. There are lots of firms who do it. Some are very good at credit, some are very good at marketing, and it's hard to tell by looking in the rearview mirror who has great credit expertise because we've been in such a benign period. And so right now if you look at historic risk-adjusted returns, they don't really tell you much about the quality of the underwriting. What folks have to do is really look under the hood and look at the loans and how many have had amendments and the like. And then I think when the tide goes out—and they will—there will be losses, but they're probably going to be smaller losses than folks would have experienced in their public equity book. And there will be people who did a good job and people who did a poor job, but folks need to really underwrite the quality of the credit underwriting.
May I add something to that? I agree 100% with those comments, but I would say my advice to all of us asset allocators is there is not enough stress testing of our assumptions. And there is the broadly held assumption there's plenty of capital, but when I look at demands—AI alone, they were quoted as $6 trillion worth of capital needed. So we're talking about trillions with an S. So one assumption we're making is there's a lot of available capital to be put to work for all these opportunities. And the other assumption is actually liquid asset classes are in fact liquid. I can tell you as a foreign exchange trader—and I mean, you remember Long-Term Capital, these were noble, brilliant strategies. They made one wrong assumption: that what they thought was liquid became very illiquid. UK gilt market, this is ancient history, 2022, sovereign debt of the UK collapsed basically in terms of value and price. And so for me, the energy industry—and I know at Morgan Stanley we did a lot of stress testing over our scenarios—that if your assumptions turn out to be wrong and you go bankrupt, whatever it is you have is too big. So I remember in '07, I came back from California and this brilliant mortgage originator said, 'Zoe, you guys, you're talking about complexity, opaqueness, so you really are looking at assumptions that if you say you're going from mark-to-model to mark-to-market, you're all in trouble.' This is in '07, equities were making new highs, fixed income knew Lehman was dead. So for me, and again I don't know that this is the outcome, but it's a zero possibility, and we all need to stress test our portfolios. If those assumptions are wrong, what does your portfolio look like?
I want to move the conversation on to opportunities and different asset classes, and one that poses a really interesting question both in terms of liquidity and democratizing investment is of course digital. Dan, why don't you walk us through your thesis here and whether more investors should be exposed to digital assets?
Yeah, I think it weaves into this macro story. There are no working-age people that have invested in a rising rate environment. Bonds started rallying in 1982 and the Fed has basically bailed you out of any potential mistake you've made in investing. And so without the Fed to bail you out, you have to look for new assets, new opportunities. And I think the fiscal-monetary situation the US and other countries find themselves in is pretty precarious. The US is running a record deficit with the most wonderful economic statistics. If anything bad happens, it will get very ugly. And inflation is still debasing your money at 3.2% a year. If you let that happen over your entire lifetime, you lose 90% of the value of your currency. So you have to look for different asset classes. Another way to think about it is alts really are not alternative anymore. It's 20 trillion. When I started in hedge funds in the 80s, there was probably 20 billion in alternatives. With a thousand times more money chasing things, it's harder to find returns. So you have to find something with an excess return and low correlation to the rest of the financial assets. And everything is totally correlated now, right? All risk assets go up and down together. And it's not because there's any intrinsic correlation between the cash flows of these assets, it's because everybody's portfolio is the same. We all own the same stuff. And so I believe blockchain has an important role in a portfolio because it's totally uncorrelated with risk assets and has an amazing expected return. The correlation over the last 13 years of Bitcoin, as a proxy for our industry, with the S&P 500 is 0.1. So it's one of the only major assets out there with zero correlation. The amazing thing about the returns though is our first fund has an 11-year compound annual growth rate of 83%, which sounds amazing. When you compound it for 11 years, it's up 1,000x. So if you can find an asset where you can get 80% return per year with zero correlation to the S&P, you have to have a tiny bit in your portfolio.
Other than Zoe, who is of course purely invested really in the digital world, the other four—are any of you invested in digital assets like crypto?
In a very modest way, listening to that argument.
The first is fiduciaries were just hesitant to go new places, and so want it to be more proven. Frankly, I think the problems with FTX and others set the industry back a while. We were probably closer a few years ago than we are today. One. And second, for us, just in our experience—and we've been doing some clever things in sort of Bitcoin put writing and others—during the five years or so that we've been playing with it, our investments at least have been far more correlated to NASDAQ than we had hoped. We had hoped it would be more diversifying than our experience narrowly has been. But you're looking at more idiosyncratic opportunities than we are.
