‘Ah beer, the cause of and the solution to all of life’s problems’ Homer Simpson
In asset management it seems that it’s always a good time to invest; when markets are down it’s a great opportunity to buy ‘cheap’, when markets have been strong, the appeal is to ‘FOMO’; the refrain is ‘look at the returns so far, do you want to miss out?’
In over three decades in the industry, I cannot recall a time when asset managers were advising staying clear of financial markets, other than perhaps in the midst of the 2008 financial crises.
Success in investing is as much art as science. Also, the difficulty of timing entry and exit is hard, hence the aphorism that ‘time in the market is more important than timing the market’. There are however certain rules that investors should take note of, as these rules will help increase the odds of success. These rules are even more important in private markets than listed markets, given the difficulty of changing course. What are these rules?
Rule 1
Understand and take note of Marathon Asset Management’s capital cycle philosophy1. This is about understanding supply versus demand. The philosophy questions why investors spend 90% of their time on modelling or understanding demand, and only 10% on supply. For an investor looking to deploy capital, this means being aware of how much capital (the supply) is chasing investment opportunities (I will call these ideas). The greater the supply (of capital) the lower the expected return. This is especially as investors often chase the same or similar ideas. Indeed, investment bubbles are created by excessive capital chasing a small number of ideas.
The lesson here is, all other things being equal, investors running away from an opportunity increases the expected return. The higher the supply of capital chasing good ideas, the lower the expected return and the lower the supply of capital chasing good ideas the higher the expected return.
As we can see from the chart we are in an environment with significantly lower supply of capital than the last few years.
Rule 2
The richness of the investment ideas (the demand). A reduction in supply (of capital) with no reduction in the richness of great investment ideas provides a fertile environment for investors. What confidence do we have that private markets and venture capital continue to generate great investment opportunities?
There is no one chart that we can turn to for this evidence. What we know is that we are in a midst of a new renaissance, propelled by AI, digitization, democratisation of distribution via apps, and more brains than ever working on the big problems (sustainability, aging populations) that needing to be solved. Innovation and disruption are all around us. One need not look far for evidence that there are abundant good investment ideas seeking capital. Many of the solutions to societal problems are coming from private markets, especially venture as they are the real risk takers and also therefore the wealth creators.
Rule 3
In listed markets we can simplify the two main styles of equity investing; value investing is about buying good companies very cheaply, growth investing is about buying outstanding companies at a reasonable (note: not cheap!) prices. Venture Capital and Private Equity is about growth investing. Valuations in unlisted markets have fallen, in line with public markets albeit with a lag. So entry levels for new capital are lower.
The lack of froth also means that the funds have more time to carry out their due diligence, to be more selective and given the reduced supply of capital be in stronger position to negotiate the entry price. Providers of capital have very strong pricing power over those seeking capital. All of this reduces the funnel of doubt and increases the expected return.
We can summarize the above as follows:
- Supply (of capital) > demand (from new ideas) + high valuations = higher risk and lower return expectations
- Supply (of capital) < demand (from new ideas) + lower valuations = lower risk and higher return expectations
All markets including unlisted have been exuberant until 2022. The exuberance has been replaced by caution. We have moved from A to B into an environment which is more fertile and clement for private market investors. This chart below from Pitchbook summarises this
Explanation
The indicator uses deal-level data to quantify how start-up friendly or investor friendly the capital raising environment is. The indicator captures Pitchbook’s deal term, deal attribute, fund raising and deal flow data to compose this indicator to compare early-stage, late-stage and venture growth state dynamics.
This content is for information purposes only. Treble Peak does not provide investment or tax advice, and information on this website should not be construed as such. Potential investors should seek specialist independent tax and financial advice before investing in any alternative investment. Past performance is not a reliable guide to future returns. Your capital is at risk.
- Capital cycle matters for investing’ Edward Chancellor, Financial Times, 29 March 2016 ↩︎
