Alternative Asset Classes Are Flooded
Alternative Asset Classes Are Flooded
Private Credit is the Latest Tsunami
The Danger of Voicing Uncomfortable Truths
“You will perceive, Sir, I have neither flattered the state nor encouraged high expectations. I have thought it my duty to exhibit things as they are, not as they ought to be.”
—ALEXANDER HAMILTON (August 13, 1782)
In the summer of 1782, the Revolutionary War had taken a devastating toll on the American colonists. Robert Morris, Superintendent of Finance for the Continental Congress, dispatched several trusted leaders to report on economic conditions throughout the land. Alexander Hamilton was assigned to the colony of New York. He was deeply troubled by what he saw, but unlike many of his compatriots, Hamilton refused to encourage false confidence. Instead, on August 13, 1782, he drafted a letter to Morris that reported conditions exactly as he saw them – no worse and no better. He did this because he believed that reporting the truth would benefit everybody in the long term—even if it painted a picture that was painful to accept in the short term.
I recalled this quote often while writing Investing in U.S. Financial History because my research led me to several deeply contrarian conclusions that many people do not want to hear. This is because human beings tend to instinctively reject such messages. Many go even further and attempt to disparage the messenger. If your insights are wrong, you risk being labeled a fool. Even if your insights are right, you often still bear the scarlet letter of a fool until the slow passage of time validates your position. That is the reality that one must accept when choosing to release deeply contrarian perspectives into the wild.
Several such insights are scattered throughout Investing in U.S. Financial History, as well as several articles I have written over the past few years. Examples include a markedly different perspective on the unsustainable and irresponsible accumulation of public debt over the past 75 years; a lonely view that the Federal Reserve’s pivot on monetary policy tightening in September 2024 constituted a grave, unforced error; and finally, a strong view that many widely accepted practices in the investment management profession are counterproductive and wasteful.
The third insight is the focus of this newsletter. It summarizes several observations from two articles that I published today, October 24, 2024. The first appears in the Fall issue of the Museum of American Finance’s Financial History magazine, and the second appears in the CFA Institute’s Enterprising Investor. I anticipate that many subscribers will disagree vehemently with these insights—and they have every right to maintain their position. Nevertheless, I hope you can approach this newsletter with an open mind. Even if the insights have no effect on your philosophy, perhaps they will at least encourage more rigor in your investment decisions—and that is never a bad thing.
Article #1—A 45-Year Flood: The History of Alternative Asset Classes
“Once a majority of players adopts a heretofore contrarian position, the minority view becomes the widely held perspective.”1
—DAVID SWENSEN, late CIO of the Yale Investments Office
Link: https://fhmagazine.org/mag/0040396001729770149/p12
The first article recounts the 45-year flood of institutional capital into alternative asset classes, such as venture capital (VC), buyout funds, hedge funds, private real estate, and private credit. The rain began in 1979 after the Department of Labor tweaked its guidance on the “Prudent Man Rule” under ERISA. This provided trustees with the flexibility they needed to invest in VC funds, which, in turn, provided desperately needed capital to fuel the technological revolution blossoming in Silicon Valley. Since then, allocations to alternatives have massively increased, but with each passing year, allocators seem to apply less discretion when assessing the overall prospects of these asset classes and selecting fund managers to fill allocations.
The most important lesson from this article is to recognize that alternative asset classes follow a distinct cycle, which is summarized below.
Formation: A legitimate void appears in capital markets. For example, in the aftermath of World War II, U.S. companies had a wealth of opportunities to commercialize war-related technologies, but banks remained skittish because of their experiences during the Great Depression. This prompted the formation of the VC industry.
Early Phase: Innovative capital providers generate exceptional returns as the number of attractive opportunities exceeds the supply of capital available to fund them. The experience of early VC and buyout fund investors, such as the Yale University Endowment in the 1980s, is an excellent example.2
Flood Phase: In pursuit of new revenue streams, amateurs and opportunists launch a barrage of new funds, and then a stampede of followers eagerly provides capital to fund them. This invariably compresses future returns because the supply of capital far exceeds the number of attractive investment opportunities. In 2024, all major alternative asset classes — including VC, private equity, private real estate, hedge funds, and now private credit — have attributes that are squarely consistent with the flood phase.
When investment consultants, OCIOs, and staff encourage trustees to maintain, increase, or just further complicate allocations to alternatives, they often frame it as if is an attractive, contrarian opportunity. The truth, however, is that it is highly conventional. To give you a sense of how conventional it has become, even Vanguard’s former OCIO clients—which once resided in a rare oasis—appear to be at risk of succumbing to the lure of alternatives following the acquisition by Mercer earlier this year. Ironically, the most unconventional strategy is to take a passive approach. The $60+ billion Nevada Public Employees’ Retirement System (PERS) adopted this approach and allocated almost entirely to index funds. This strategy has outperformed 89% or more of their peers consistently over the past 20 years—and that is before their substantial fee advantage is taken into account. Sadly, hardly any trustees emulate this unconventional strategy.3
In 2024, alternative asset classes are heavily flooded. According to Equable, the average public pension plan held 33.8% in alternatives in 2023 versus only 9.3% in 2001. The flood of capital forces allocators to navigate murky waters that are teeming with naïve amateurs who lack the skills to succeed and free-roaming opportunists who lack the will to be fiduciaries. Many fund managers, as well as the consultants and advisors who recommend them, qualify for both unseemly titles. This is why trustees must apply maximum skepticism when presented with alternative asset class investment recommendations.
Article #2—Wall Street’s Latest Flood: Private Credit
“They seemed to spring up like mushrooms—practically overnight and often in the dark—and like mushrooms, they could be dangerously difficult to distinguish between.”4
—ANDREW BROWNING, author of The Panic of 1819
Link: https://blogs.cfainstitute.org/investor/2024/10/24/wall-streets-latest-flood-private-credit/
After Congress failed to renew the charter of the nation’s first central bank in 1811, state-chartered banks proliferated throughout the country. These banks issued private loans with little discipline and almost no regulatory oversight. The deterioration of lending standards accelerated rapidly in 1816 and 1817, when farmers and speculators rushed to obtain loans to purchase large tracts of land in the Midwest to grow wheat and cotton. Prices of both crops had skyrocketed after global crop yields collapsed in the wake of global cooling caused by the eruption of Mt. Tambora in 1815. But when temperatures returned to normal in 1818, crop yields recovered, commodity prices collapsed, farmers defaulted on their loans, approximately 30% of state-chartered banks failed, and the United States descended into its first Great Depression.5
The article in the CFA Institute’s Enterprising Investor explains the dynamics of the more recent, twenty-first-century private credit boom. Although it is highly unlikely to end as catastrophically as the one in the 1810s, the underlying causes of the explosive growth bear many similarities. The current private credit boom began after the 2008/2009 Global Financial Crisis (GFC), which forced the U.S. commercial banking system to tighten lending standards and restrict loan issuance in several market segments. This enabled banks to restore their depleted reserves and strengthen their balance sheets, but much like the demise of the First Bank of the United States in 1811, it created a temporary void in capital markets. This, in turn, triggered a sharp rise in demand for private credit. Figure 1 shows the rapid increase of private credit fund assets under management (AuM) since 2005. Most studies project that investment in private credit will only accelerate in the coming years.
Figure 1: Total Private Credit Assets Under Management (AuM) (2005 - 2023)
Sources: Financial Times, Prequin, The Wall Street Journal; CION Investments.
Private Credit is Not an Allocation; It is a Skill
“You don’t want to be average; it’s not worth it, does nothing. In fact, it’s less than the [public] market. The question is ‘how do you get to first quartile?’ If you can’t, it doesn’t matter what the optimizer says about asset allocation.”6
—ALLAN S. BUFFERD, treasurer emeritus at the Massachusetts Institute of Technology (2008)
There are many red flags that indicate when an alternative asset class has breached a levee. Several are plainly visible today in private credit markets. One subtle red flag is when managers stop emphasizing return enhancement, and, instead, favor vague claims of diversification. Such claims are far more difficult for trustees to verify, and far easier for consultants and staff to exaggerate (or even fabricate entirely). Another bad sign is when the practices of asset managers shift to accommodate a more challenging investment environment. A recent article by Steven Kelly, associate director of research at the Yale Program on Financial Stability, noted several examples of such shifts occurring in private credit markets. Finally, an especially troubling red flag is when fund managers begin targeting retail investors. Sadly, individuals are almost always the last victims to have their heads dunked in alternative asset class floods.
Despite many red flags, private credit recommendations are now seemingly ubiquitous on the meeting agendas of institutional investment plans. This also happens to be a red flag in and of itself. Trustees must exercise extreme skepticism when presented with such recommendations. Once an alternative asset class breaches the levee, only a small subset of highly skilled investors is qualified to venture into the treacherous waters. It is a skill-based decision, not an allocation choice.
Track Records are the Only Private Credit Assets in Short Supply
“No box score is kept in the investment-counsel game and no batting averages. My own method of research was to ask a number of investment counselors how their clients were doing. They all replied that their clients were doing quite well, thank you, taking into consideration, of course, this, that and the other.”7
—FRED SCHWED, JR., author of Where are the Customer’s Yachts? (1940)
The need for skill in private credit—and all alternative asset classes for that matter—is a critical prerequisite that few consultants, staff, and OCIOs address. If consistent and sustainable “first quartile” performance is essential for entry into an alternative asset class, then by far the most important decision criterion is the track record of the firm and/or individuals recommending fund managers to fill the allocation. Advisors must prove convincingly that they have recommended top quartile managers consistently for many years. They also need to provide rock-solid assurance that the people responsible for the track record are still at the firm and are capable of training the next generation of specialists.
The problem is that unlike the oversupply of private credit recommendations, there is a chronic undersupply of credible track records. It would be prudent, therefore, for trustees to assume that advisors, consultants, and staff members who refuse to provide compelling track records either have something to hide regarding their skills, or perhaps they simply lack a track record because they are really just amateurs and opportunists seeking to boost their careers and profits by needlessly plunging their clients into the latest flood.
Disclaimer: This is a personal newsletter. Any views or opinions expressed herein belong solely to the author and do not represent those of any people or organizations that the writer may or may not be associated with in a professional capacity, unless specifically stated. This is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, service, or considered to be tax advice. There are no guarantees investment strategies will be successful. Past performance is no guarantee of future results. Investing involves risks, including possible loss of principal.
David Swensen, Pioneering Portfolio Management, 2009 ed. (New York: The Free Press, 2009).
The history of the Yale University Endowment is covered in Chapter 25 of Investing in U.S. Financial History: Understanding the Past to Forecast the Future.
The peer rankings were for the period ending March 31, 2024.
Andrew H. Browning, The Panic of 1819: The First Great Depression, (Columbia: University of Missouri Press, 2019).
Elliot Chambers and Mark Higgins, “The Panic of 1819, Silicon Valley Bank, and the Dangers of Bank Runs.” Financial History, (Summer 2023); 12-16.
Larry Kochard and Cathleen Rittereiser, Foundation and Endowment Investing: Philosophies and Strategies of Top Investors and Institutions. (Hoboken: John Wiley & Sons, Inc., 2008).
Fred Schwed, Jr., Where are the Customers’ Yachts, (Hoboken: John Wiley & Sons, Inc., 1940).