Invest Like the Best with Patrick O'Shaughnessy
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: Leverage always plays a role, and they're all connected. But just the mismatching of assets and liabilities. You could be the best investor in the world making the best illiquid investments, but if someone comes and asks for your money in a quarter when you haven't had time to actually have that investment play out the way that you underwrote it to do, you're going to be a bad investor. You're going to get called out of your option, and you might have to sell it at a deep discount. So there's a few things. I think it's one, anytime you bring retail or individuals, so think about people depositing to a bank next to principal risk-taking activity. I think that's one thing. The second thing is just anytime you mismatch assets and liabilities. And then the third thing, again, going back to what we talked about earlier is what are the incentives? What are the guardrails? And what's the market structure? [00:00:00] S0: Okay, so then what happens? Obviously, we know the global financial crisis is terrifying, and the reaction is many things. But what is installed post-GFC that sets the seed for, I guess we'll call the current system, System 3?
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: Okay, so then what happens? Obviously, we know the global financial crisis is terrifying, and the reaction is many things. But what is installed post-GFC that sets the seed for, I guess we'll call the current system, System 3? [00:00:00] S1: So in 2010, two things happened. First is, Basel III was passed by G20 nations, and I'll explain what that is. And the second thing is Dodd-Frank. When you think about Basel III, so this applies across all commercial banks. And by the way, a number of investment banks that were not commercial banks were forced to become commercial banks as a result of this. Those commercial banks – and this is really a Basel III thing – had restrictions on capital, which for your audience, think about that as leverage. So the amount that they could be levered up, so they didn't get levered up 30-to-1 or 40-to-1 like they did pre-GFC. And the second thing is restrictions on liquidity. And liquidity is basically, through a bunch of shock scenarios, a bunch of things going wrong., do you have enough liquidity to meet all your obligations? That was a key part of it. Dodd-Frank was more aimed at, in the Volcker Rule – that didn't really last long – was really aimed at the principal investing activity. I would say it's more for the commercial banks. It was more Basel III, but Dodd-Frank played a big role certainly in the short term. [00:00:00] S0: How would you explain just System 3 and its guardrails and incentives to people out there?
· Alan Waxman
[00:00:00] S1: System 3, in my opinion – it took like 125 years to get here – has the potential to be the best system American finance has ever had. Because when you think about commercial banks or deposit-taking institutions, by the way, that are basically backstopped by the government, insured by the government through the FDIC. So think about GFC. There was a bailout, the taxpayer bailout. That's not good for society. That's not good for the middle class. That was not a good outcome for America. For those institutions, having restrictions on capital or leverage and liquidity, where they're doing lower risk-taking activity to finance a system, that's a good pillar of any financial system. Conversely on the other side, and this is where the current moment starts to come in, is now you've got private capital coming in. So when you think about private capital, think about pension funds, sovereign wealth funds, endowments, insurance companies, providing capital. In the beginning of this period, so-called System 3, Post-Basel III, Post-GFC, that's what resulted in the growth of the private capital industry because it was filling in the gap. So think about principal risk-taking activities. Private capital is filling in the gap. And with the exception of hedge funds and really REITs, those were matched assets and liabilities. So you think about private equity, private real estate, private infrastructure, private credit. They never had someone that could literally ask for their money back, or they didn't have depositors saying they need to get their money back, they can't get it back because of illiquid assets. So just to put it in context, private capital from pre-GFC to post-GFC. It was about $2 trillion pre-GFC. It's grown to around $14-15 trillion. Private credit, which is in the news today, grew from $500 billion to about $2 trillion, where it is today. So massive growth. And this filled the gap for that principal risk-taking capital to provide risk capital to all parts of the American economy, which is a good thing. And I would say up until 2018, the system was working great. You had commercial banks, deposit-taking institutions, effectively back-stopped by the government, doing safer things. And then you had matched assets and liabilities where an investor, a set of assets, couldn't get called out of an option, providing the risk capital.
· Alan Waxman, Patrick O'Shaughnessy
That's a pretty good system – until we started to see behavioral changes in 2018. [00:00:00] S0: Just to put a pin on an elegant well-designed system of guardrails and incentives. The commercial model where it's lower risk and protected or backstopped and higher risk-seeking capital where the assets and liabilities are matched is a good system. [00:00:00] S1: It's a good system. All crises generally are caused from not credit issues or others. They might start in other issues, but it's mismatched assets and liabilities. [00:00:00] S0: So you mentioned the year 2018 as being a pivotal point. I want to explain that transition, but it feels important. You and I have talked about this notion of yours of the factory model before. We're going to go into that in more detail, but just to plant the seed in people's mind, define the factory model just briefly, and then I want to talk about what happened to get us transitioned and the incentives towards that model.
· Alan Waxman
[00:00:00] S1: So the way that we define the factory model in our industry is there's two parts to it and then there's an output. First part is the industrialization of the fundraising process. Say liability gathering. Literally raising as much capital as you possibly can, as fast as you can. So that's the industrialization of the liability side of the fundraising side. That comes first. And then what comes second is then, as a result of that, the industrialization of the asset side. So think about investing. If you're on an investment team and all of a sudden your firm has a lot of money to invest, and it's just sitting there and maybe there's a timestamp on it. All of a sudden your behavior has to start to change, because you have to deploy that money much quicker. And what's the best way to raise a lot of capital quickly? Make it very simple. Make it very narrow, because if it's wide, that's too hard to explain. So you want to make it as narrow as possible and you're also willing to take – let's say, make concessions on the type of capital you raise. Meaning maybe it's got a term where they can ask for your money back. So instead of perfectly matched assets and liabilities, maybe you're willing to start to not have perfectly matched assets and liabilities because you want to raise it as fast as possible. And again, when people hear this, they're going to think I'm only talking about the bigger firms in our industry, but it filtered down to mid-sized firms, smaller firms for a whole bunch of reasons, but this whole factory model behavior started to reveal itself in 2018.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: The visual that's coming to mind on the asset side, and again, we'll come back to both these ideas in more detail. But I think of an artisan making a horse saddle or something by hand ,and then I get an order for 100,000 horse saddles. I can't make it by hand. I've got to make a factory. [00:00:00] S1: That is the exact way to think about it because it's a different model when you're building that horse saddle, versus you get a massive order. But one point that's important is that it starts always on the liability side, and then it goes to the asset side, and then you get the current moment that we're in that I know we're going to talk about. [00:00:00] S0: It starts on the liability side because why? [00:00:00] S1: Because if you just all sudden go to that example – it's a really good example – of the horse saddle. All of a sudden, if you don't have a factory that can produce 100,000 on the artisanal side, you're not ever having to think about it. You could have an industrialization of the asset side, but if you're liability constrained, you're not going to change behavior because you don't have the capital to go do that. You'll run out of money in five days. So it's got to start on the liability side where you raise all the money. Then you have it, then the behavioral change starts. These two things, it's first liability side, it starts the industrialization and as a result of that, it goes to the asset side.