Ian Rushbrook, the idiosyncratic manager of the Personal Assets investment trust in Edinburgh, had some good lines at his AGM 10 days ago, explaining why he continues to be bearish about the outlook for equities, to the point of holding 40 per cent of the trust's assets in cash or equivalents. The best moment, I thought, came when he dug out some 100-year-old quotations from an obscure economist named Knut Wicksell.
Speaking to the economic section of the British Association in 1906, Wicksell pointed to the distinction between the market rate of interest and the "natural" rate of interest. He argued that if the first were kept below the second, the economy could continue indefinitely to grow on credit alone as long as "loan-backed entrepreneurs" were around to take advantage of the cheap money that resulted.
"The thesis which I humbly submit to criticism," Wicksell went on, "is this. If, other things remaining the same, the leading banks of the world were to lower their rate of interest, say 1 per cent below its ordinary level, and keep it so for some years, then the prices of all commodities would rise and rise and rise without any limit whatever". He added, though, a key caveat: "Now this proposition cannot be proved directly by experience, because the fact required in its hypothesis never happens."
What Wicksell thought could never happen has done on at least two occasions since then, once in the late 1920s, and again more recently with the Federal Reserve's sustained phase of cheap money. For "loan-backed entrepreneurs", Mr Rushbrook says, you should today read hedge funds and private equity; and for "all commodities", asset prices in general.
Who is to blame for this? Like other investment conservatives, he says it's Alan Greenspan, former chairman of the Federal Reserve. The Fed's policy of slashing rates from 6.5 per cent to 1 per cent was "nothing less than applying a blowtorch to a case of US economic frostbite and, while resolving the problem in the short term, causing potentially enormous long-term financial damage to the world. In a Faustian bargain to avoid the recession he dreaded but knew was inevitable, Greenspan created worldwide a deadly debt mountain, the enormity of which will only be revealed over the next three years".
Strong words - but consistent ones, since Mr Rushbrook has been saying something similar for three years now. His policy of maintaining a large part of his trust's assets in cash has caused it to generate only half the market's return over the last three years, something that causes him (though not all his shareholders, it seems) little loss of sleep. Unlike most conventional funds, Personal Assets says explicitly that its objective is capital preservation with a lower degree of risk than the FTSE All-Share index. The trust is up 33 per cent over three years.
Whatever your views about his approach, the point Mr Rushbrook is right to make, in my view, is that current market valuations are supported by a huge amount of gearing, the scale of which is by no means evident to the casual investor. Hedge funds and private equity, two of the hottest current asset classes, in particular are almost totally dependent on the use of debt to produce their returns.
While most attention has focused on hedge funds, the way that the private equity market has mushroomed during the cheap money era is in many ways even more extraordinary. Hardly a day now seems to pass without one of the leading private equity firms, a KKR, Blackstone or Carlyle Group, announcing that it has raised yet another record amount for its latest fund.
Some of these funds are leviathans, $5bn-$10bn funds that will gear up several times over with the help of bank lending. They are all predicated on the idea that they can repeat what the best firms have done in the past, which is make excess returns in very short periods of time. This vast amount of cash looking for a home is what is driving the unprecedented level of M&A activity, which in turn is keeping the stock market alive (or was until the correction that started in May).
It seems obvious to me that private equity is a serious bubble in the making. The amount of money chasing a repeat of unrepeatable past returns is growing rapidly while the number of opportunities is by definition declining. The whole process is worryingly fee-led: investment banks pocketed a placing fee of $270m for a recent $5bn KKR private equity fund. The fees of the funds themselves are much higher than those of conventional funds.
Yet already there are signs that the party has become over-extended. The kind of deals being done are becoming more far-fetched. The logic behind private equity is that highly incentivised management teams can move in on a poorly performing quoted company, take it private, turn it round and then refloat it on the market. When it works (which is by no means always - you hear about the successes, but rarely about the failures), this can be highly effective and profitable. That it has been happening so much, you can argue, points to failures of management and/or stewardship by institutional investors.
Yet what private equity funds are having to do now is beginning to show signs of strain, if not desperation. One Blackstone fund, I read, recently bought a £1.5bn chunk of shares in Deutsche Telekom, a quoted company that is never going to be a quick turnaround story: why should investors pay triple their normal fees just to own a quoted company they could buy through an index fund at a fraction of the cost? Some of the M&A deals now being done also lack any industrial logic and look doomed. With so much gearing in the system, the end of cheap money could lead to some spectacular disappointments - which you can be sure will make Mr Rushbrook's shareholders feel a lot happier and a lot wiser.Reuse content