Its Easter, so let’s start with a tale of an easter egg hunts.
Imagine an easter egg hunt where each participant (child) has to contribute 10 easter eggs, they are hidden by an omnipotent gamemaster (parent), and then all participants are released to search for eggs and get to keep all they find.
What is the optimal strategy in this game?
Assuming the eggs are randomly hidden, the optimal strategy is to search for eggs where few participants are searching. If you search where others are searching, any eggs found will need to be shared amongst a large number of searchers and you will end up the loser.
Nice story – but what’s this got to do with investing!
Investing is a competitive search game. We are all trying to find undervalued opportunities that will deliver attractive returns. We compete against other players to secure these opportunities.
As any participant in an infrastructure bid process would know, this competition has direct impact on the long-term returns these investments realise. The more you are forced to compete, the more you will tend to adopt more aggressive base case assumptions (even, god forbid, assumptions that prove optimistic and aren’t realised) as well as more aggressive debt financing and exit assumptions.
Competition leads to lower returns!
Where is the most competition at the moment? I would say the most competition is for superannuation funds looking to invest in mid-risk assets with 7-10% IRRs – preferably dominated by long-term cash flows.
As risk free rates have collapsed (who wants a 1.5% return on their bond portfolio) and listed equities look pretty expensive (and the expected returns that feed into a lot of SAA models are based on a fixed premium above risk free – implying listed equity returns in the 4-6% per annum range), SAA optimisers are gorging on these mid-risk high return asset classes (eg infrastructure equity, defensive alternatives, etc).
Often the higher return of these asset classes is justified by an illiquidity premium. That’s fine, illiquidity is an unattractive trait and investors should ask for higher returns to compensate. But illiquidity also means that if lots of people are trying to allocate to this asset class, then prices will get bid up! It is a mathematical certainty that higher prices equals lower future returns.
I would argue this means the illiquidity premium for in vogue asset classes is likely to be much lower than enjoyed in the past.