AIM13 Commentary - 2023 Q3
“Be yourself, everyone else is already taken.”
As we approach the twenty-fifth anniversary of the inception of our original fund entity, which allowed our family and one other family to invest alongside each other, we continue to revisit the following questions:
Who are we?
What are we trying to accomplish and how do we get there?
How do we define success?
We often view what we do as similar to parenting. No matter how well we do it, we know we can always do better and never “rest on our laurels” or feel comfortable with what we are doing. In that regard, one would think that, after 25 years, we would have figured out these questions. However, the answers to these questions are not as obvious as one might think, and we often feel like Admiral James Stockdale during the 1992 vice presidential debate asking ourselves, “Who am I? Why am I here?”
When it comes to investing, the easiest way to describe us is a family office that invests across a wide range of asset classes using the insights and perspectives from one part of our portfolio to make us better investors in other areas. In private equity and hedge funds, we also combine resources and capital of outside investors and invest through co-mingled entities. In these ways, leveraging what we learn in one part of our portfolio for the benefit of another and leveraging our partner and manager network, we feel we can achieve greater returns, for our own capital and that of our partners aligned with us. As just one example, we recently helped one of our hedge fund managers doing work on a company by introducing him to one of our private equity managers who is active in that company’s sector.
We have no qualms saying that our first objective is selfishly to compound our own capital. We wake up every day focused on that goal. By constructing co-mingled entities with other investors, our partners’ capital shares that focus. As fiduciaries, we must act in the best interest of our clients, and we do this by aligning the objectives between what we want to accomplish with our own capital with what our investors want to achieve with their capital.
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“A lot of people with high IQs are terrible investors because they’ve got terrible temperaments…. [H]aving a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy.”
The investment world recently lost one its greatest minds in Charlie Munger, who spent his career as the confidant of his more luminous partner, Warren Buffett. His advice above is something we try to remind ourselves of often; indeed, patience is sometimes an investor’s greatest asset. While we are happy with our hedge fund strategy in the third quarter, overall we have not been completely satisfied with hedge fund returns as of late as we feel that managers have not fully taken advantage of the opportunity set.
We remain optimistic, however, that current market trends – such as elevated rates (good for shorting), an apparently resilient economy (strong labor market and falling inflation, more on that below), and the tightening money supply (which creates more dispersion between good and bad companies) – will favor our strategy in the hedge fund space. While our patience has been tested, we continue to believe that investors should not give up on hedged fund strategies.
While hedge fund returns have fallen short of our expectations recently, our private equity strategies have significantly outperformed our hedge fund investments, as they should given the illiquidity premium. We continue to believe that we should have both in our overall portfolio. In terms of “What are we trying to accomplish?”, the answer must always be superior risk adjusted returns across the portfolio. For our equity-oriented investments, we believe balancing the capital protection nature of hedge funds with the capital appreciation nature of private equity continues to make the most sense.
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When we consider how do we accomplish our goals, many investors ask us, “Why do you have outside investors?” instead of just managing internal capital. Although we are typically the largest investor in any entity we create, we think there are enormous benefits having other value add investors investing alongside us:
Deeper leverage of a team: Having outside investors provides the capital needed to attract, hire, and promote professionals and build a team. Over the years, the resources of our team enhance our initial and ongoing investment and operational due diligence, we think yielding better returns over time. We strive to create opportunities for investors to invest alongside us and with structures that skew our compensation more through incentive fees than management fees. If we deliver, that compensation allows us to attract and retain a top-notch team.
Wider sourcing of new opportunities: One of our greatest assets is our deal flow, and often our best ideas have been referred to us by our diverse network of partners. That network, which now stands at over 400 unique individuals across our entities, spans the range of family offices, investment, finance and legal professionals, current and former corporate executives, government and ex-government officials, and subject matter experts in fields that are important to us.
Broader network to vet managers and ideas: We often call upon our partners to provide references, insights and perspectives on individuals and opportunities that they may be uniquely in a position to assess. The value of this resource is a cornerstone of our investment philosophy – surround yourself with smart people and good things will happen.
Increasing our value add to our managers: Our network of partners also makes us a more attractive partner to the managers and companies we seek to partner with. Capital is a commodity, and without bringing some “value add” to our invested dollars, we would be unable to access the scarce investment opportunities that often do not need our money.
We know that we must deliver superior risk adjusted returns, and, as mentioned above, critical to that objective is an alignment of interest between our own and our partners’ capital. We strive to achieve this alignment in several ways. For instance, we will never put outside investor capital into a fund, deal, company or other opportunity that we have not personally invested in. Similarly, our entities with outside investors always get the first bite. Given that many opportunities we see are capacity-constrained, we must ensure that any investment opportunity is first considered for the entities that have outside investors. Only if it is not suitable for such entities or there is excess capacity will we invest personally. We also hold our managers to these standards, as alignment at the investment level is as important as it is at our level.
In terms of how do we define success, as we finish our 25th year, we have spent time thinking about where we want to be in one year, five years, and even twenty-five more years. Across these time periods, above all else we want to be known for never having to say sorry for our actions. We will not always be successful. Even Ted Williams, thought to be the greatest hitter of all time, “only” batted .406 in his best season. When we do get things wrong, we must recognize our mistakes and what we got wrong, learn from them, and move forward as better investors.
“Reputation is what people think of you. Character is what you are.”
We may not be successful in achieving our goals, but if we wake up every day and single-mindedly work towards these goals, we are confident that we will be able to achieve something special for our capital and our partners’ capital invested alongside us. People’s first question when they meet an investment manager often is “What are your assets under management?” We do not think that is the right question. We think the right question is “What is your track record?” – in generating returns and in doing the right thing. When it comes to investment returns, our track record for the investors who have partnered with us over the last 25 years speaks for itself. Over the next 25, we hope to continuously improve and build upon that foundation.
The Passing of Our Friend and Mentor, Byron Wein (1933-2023)
We wanted to mention another investment great who passed away recently, Byron Wein. The opportunity to sit next to Byron at many Pritzker Family Foundation meetings over the years gave us countless investing lessons that have shaped our long term approach. He also inspired us with a lot of the thoughts, guidance, and wisdom that are behind many of our quotes that we live by and that have appeared in our prior letters, such as these below:
Prudence: “The good thing about always being bearish is that you’re never wrong, just early.”
Diligence: “It is not only what you make but also how you make it that matters.”
Humility: “Surround yourself with smart people and good things will happen.”
Character: “Past performance is not necessarily indicative of future performance… unless you’re talking about someone’s character.”
We have included here Byron’s 20 Life Lessons and an article he wrote in 2002 that we still share to this day (Byron’s The Inherent Instability of Hedge Funds). We were honored to know him.
Market Observations
Some of the things we are seeing in recent months that have us continuing to maintain a cautious outlook include:
Challenges Facing Venture-Backed Start Ups. According to a recent New York Times report, approximately 3,200 private venture-backed U.S. companies have gone out of business this year, based upon Pitchbook data. Those companies had raised a stunning $27.2 billion in venture funding. Carta, the financial services firm for many start-ups, reported that 87 of the start-ups on its platform that raised at least $10 million had shut down this year as of October, twice the number for all of 2022.
Source: Carta
Another indicator of this trend is the surge in demand for companies in the shut-down business. SimpleClosure, a start-up that helps other start-ups wind down their operations, has barely been able to keep up with demand since it opened in September, according to its the founder, Dori Yona, as reported in the New York Times. The permanent loss of capital in the venture space has been stunning, and we expect it to have a chilling effect on new capital raises going forward.
Lending to Large Buyout Firms. Bloomberg reported over the summer that Citigroup cut back its business of lending to buyout firms as part of the firm’s larger push to improve returns across its institutional business. Citi’s CFO was quoted as saying that the bank had “pretty significantly” reduced its portfolio of subscription credit facilities. As fewer banks lend to buyout firms and those that are charging higher rates, private equity firms must contribute more equity. Similarly, private equity firms are increasingly looking to refinance debt. According to a report in the Wall Street Journal in October, U.S. private equity-owned companies refinanced about $51.67 billion of leveraged loans this year through September, compared with about $16 billion in all of last year, based on PitchBook data.
Source: Wall Street Journal based on Pitchbook Data/LCD
What this all means for the private equity industry remains to be seen, but we have always avoided private equity strategies that use a lot of debt to drive returns since they have risks that are not apparent when rates are low. As we said above, it is not only what you make but how you make it that is important.
Retailers Leaving the Inner City. According to a New York Post report in September, Target announced the closing of nine stores in inner-city locations across the country, including in Harlem, after receiving, in some cases, over 100 emergency calls arising from thefts to hit-and-run’s. Employee safety was also a major concern. The underlying causes driving the closures included the flight of higher earners from the areas, labor shortages, and the continued trend to online shopping. With these areas already facing challenges (rising crime, shrinking tax basis, homelessness, etc.), the disappearance of retailers that the working class needs will only make a bad situation worse. We think that the follow-on effects of this trend – in terms of city budgets, empty office space, and greater dispersion of wealth – will not have a positive impact on the overall economy.
Within cities, both residents and retail firms have shifted from downtown to suburban areas.
Source: JP Morgan Chase Institute
Recession Remains a Threat. Over the past eighteen months, the Fed has raised rates by 525 basis points, its biggest tightening of monetary policy since 1981, according to a report in early November by the CME Group. Only very recently has the Fed indicated that it may be time for cuts. With inflationary threats abating faster than most expected, a new concern is that the Fed overshot its mandate, and its aggressive rate hikes may push the economy closer to recession than previously expected. Just because there is no recession now does not mean we will not still experience one as a result of this policy.
Recessions Often Follow Tightening Cycles By About 9-18 Months
Source: CME Group
We welcome any questions or thoughts you may have.
Sincerely,
AIM13