Comparing investing to gambling might not generate the best response from potential LPs, but that’s exactly what Oaktree Capital Management co-chairman Howards Marks did in his latest memo, one that is applicable to late-stage credit cycle investing in private equity and private debt.
The crux of the memo sheds light on Marks’ investment philosophy: “Success in gambling doesn’t go to those who pick winners, but to those with the ability to identify superior propositions. The goal is to find situations where the odds are generous to one side or the other, whether favourite or underdog. In other words, a mispricing. It’s exactly the same in investing.”
Successful poker and gin players, to name two of the card games Marks discusses, do more than value their decisions based on the outcomes. Rather, their success comes from a rigorous process rather than relying on hunches or luck, he argues.
The “superior investor” can gauge revenue and profit potential, where we are in the credit cycle and the fairness of an asset’s price better than most. In private credit, the question arises around credit spreads – am I being paid adequately for the risk I’m taking? Within private equity, how rich a price is too rich?
These are all questions that no longer have easy answers. The few direct lenders who saw the potential that private credit offered in 2010 and 2011 likely made outsized returns for a minimal amount of risk; the fewer firms that offer a service, the higher a price those that offer it can charge. But that time is no more.
For private equity managers, the question is how they can find bargains in a late-cycle atmosphere, and as Marks notes in a previous memo, a bargain denotes a good value rather than a cheap price. With valuations elevated, the question becomes which assets can actually command a rich price and which, while seemingly expensive, actually constitute a “smokin’ deal”?
“No one gets these things right all the time, but the superior investor does so more often than most,” Marks writes.
When gauging the outcome of a bet, Marks notes, there are three overriding factors: how good is the player’s position, how many ways can they win and to what extent does their chance of winning depend on luck.
Many credit managers will argue that scale betters their ability to compete and gives them more resources and paths to a favourable outcome. They likely wouldn’t be wrong.
We saw the largest credit managers displace syndicated markets multiple times in 2019, and there’s no reason to think that trend will end. The syndicated market may still prove to be the option of choice for many in a less volatile market, but direct lenders are now a legitimate option when seeking $1 billion-plus financings.
Marks offers an anecdote to bolster his case: early in his career, when he took a summer job at First City National Bank in 1968, the bank invested in the highest-regarded US businesses. But if a person put their entire portfolio in those names and held them for five years, that investor would have lost almost all their money. Then, in 1978 while at Citi’s bond department, Marks made money “safely and steadily” by buying and selling “junk”.
The result, Marks concludes, is that skill in investing is measured by selling things well rather than buying good things – as well as the acumen to know the difference – and the importance of purchase price rather than what an investor is purchasing.