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“An undertaking of great advantage…”

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The economist Michael Hudson has a useful expression contrasting the Economic Models of the West with those of emerging Asia as Industrial Capitalism (Asia) versus Financial Capitalism (the West), where the latter is in effect a return to the rentier or landlord class of extractive capitalism. He has been writing about this for many years and this speech as he updates his book Super-Imperialism is as good an introduction as any. The key point is that investors are being offered two different models of return generation; the Industrial Model, where the capital is invested to generate returns in the real world which translate back into dividends for the investor, or the Financial model in which the capital raising process is largely about generating returns to the financial sector, with the actual production process largely incidental.

There are a number of examples of innovation in rentier capitalism this week. First there is the headline in the FT today about the next round of Special Purpose Acquisition Companies or SPACs as they are known. To recap, this is an ‘innovation’ that allows highly connected and skilled rent extractors to raise large amounts of money for the purpose of bringing companies to the public markets without the need for any of the onerous regulation, disclosure or due diligence of an Initial Public Offering or IPO. In effect the SPAC is launched as a public company which is effectively just a well capitalised ‘shell’ that will subsequently identify and buy out a single targeted private company and deliver it a stock market listing through the back door. Investors essentially trust the managers to find and deliver a company, somewhat reminiscent of the famous line during the South Sea Bubble (as detailed in Mackay’s Extra-ordinary popular delusions and the Madness of Crowds) raising money for “a company for carrying out an undertaking of great advantage, but nobody to know what it is”.

These SPACs are being fronted by famous ‘names’ in finance on the (in our view extremely dubious) basis that their experience of, say, running a large European Bank is an ideal qualification for identifying and developing an unlisted fintech business. The FT article highlights former UniCredit chief Jean Pierre Mustier, who is getting together with LVMH tycoon Bernard Arnault, to launch a SPAC,  while the former boss of Credit Suisse, Tidjane Thiam has plans to do something similar, as do former UBS boss Sergio Ermotti and ex Commerzbank head Martin Blessing. At a guess, none of these would likely raise much capital from anyone that had ever worked with them, but that’s not really the point, they are just ‘front men’ in the manner of George Clooney or Ryan Reynolds selling their tequila and gin brands respectively. The ‘great advantage’ is most likely to go to the founders of the SPAC, who award themselves 20% of the Equity as well as a health ongoing management fee. 20 and 2 rather than 2 and 20.

The second announcement from the financial extractive industry was made last week by hedge fund Marshall Wace who plan to launch a fund to participate in ‘late stage venture capital’, in effect pre-IPOs, and then intend holding the positions for the longer term in the manner of Private Equity – at least in terms of locking up investors’ capital – and charging for it. In effect this positions them in ahead of the large institutions taking the IPO, allowing them to extract an illiquidity premium as a capital gain on IPO, but also to benefit from a lack of mark to market volatility and a lack of liquidity being available to their own underlying investors. Thus once again they are looking to the area (VC or PE) with the highest fees and trying to position themselves to benefit by being a hybrid, with all the advantage to the manager over the investor. The investor has their money tied up, pays a much higher management fee than they would for a ‘normal’ fund while also likely giving away a performance fee that will encompass a return for the illiquidity risk that the investor took (not the manager) as well as most likely some sort of beta, or market performance on account of having an inappropriate benchmark. For example, a concentrated portfolio of health tech stocks is a smart beta strategy and should be judged against an equally high risk benchmark rather than against a lower risk market portfolio.

This structure – similar to something being done by Dan Loeb’s Third Point – is no doubt at least in part inspired by the issues that surrounded Neil Woodford, whose announcement of a plan to return to markets are the third story this week. Woodford famously developed a powerful performance track record through an extended period that included the Dot Com crash of 2000, when he avoided tech shares and the Global Financial  Crisis (GFC)  when he avoided bank shares. In essence, he took on a particular form of risk, which was benchmark risk, in order to generate his returns. However, having set up his own eponymous (always a bit of a red flag) fund management business in 2014, he appears to have shifted his source of return and hence his source of risk, by investing in small and illiquid stocks, especially in biotech and healthcare technology, the same area that MW are now looking at.  This is an entirely valid strategy so long as the underlying source of the funds is stable, which is not really the case with unit trusts, but is clearly what Loeb and Marshall Wace are considering.

Duration mis-match, offering daily liquidity while investing in illiquid underlying assets, has been an issue since the days of bank runs in the 18th century, indeed it led to the wholly avoidable but hugely damaging debacles of Northern Rock and more pertinently Kaupthing and the Icelandic Banks. Then, as with Woodford, large numbers of retail investors and a number of local authorities and small scale institutions were encouraged to take the outsized rewards without any recognition of the risk that was being taken to generate those rewards.

If someone is offering an outsized return but claims there is no additional risk, they are either deliberately not telling you what the risk is, or they don’t understand what they are doing. Neither is good for the end investor.

In his interview, Woodford says “my investment approach never changed” while simultaneously admitting “if I was running retail funds in future I wouldn’t mingle unquoted assets in a retail fund”, something he did at Woodford, but not at Invesco. He then goes on to point out how well his unquoted assets have done since the administrator liquidated them and his plan to focus on Biotech but with a different set of investors. Perhaps he will sell his late stage stuff to Marshall Wace?

The final story this week isn’t one story, it’s almost every story in the financial trade press at the moment, ESG. ESG is everywhere, every large firm is ‘investing’ in it, (including naturally, and in case you were worried, Marshall Wace. That was one of last year’s many MW stories in the FT.) Every corporate announcement is about how someone is being moved to ‘build the ESG function of company X’ or how company Y has won an ESG mandate, while every day there is another story pushed by political lobbyists on the one hand or Investment Banks on the other about how the role of institutional investors is to focus on Climate Change. The article (also in the FT) about ‘Green’ Steel is a case in point; they quote non profit climate assessment groups and NGOs that ‘promote responsible investment’ as saying things like “with oil and coal, you know it needs to go away…with steel it’s more complicated.” In effect, these activists are demanding that huge amounts of capital are diverted to produce the same things as are currently being produced, just without generating any CO2 – even though man made CO2 s less than 4% of all CO2, which in turn is only 4% of all greenhouse gases. Moreover, the reality is that much of this has already been outsourced to Asia and the very places that are not rushing to limit CO2. The incentive to do the ‘right thing’ is to raise the price in the west of doing things in the old way and to ‘encourage’ western institutional investors to allocate savers’ capital to a range of ‘sustainable’ investments that are unlikely to generate a proper return. Meanwhile, in Asia, to which the west has already outsourced much of its production, the time horizon for Carbon neutral is 2060.

The financial extractive industry is all over this of course. The investment banks are heavily promoting the idea of Carbon credits and Carbon trading as a lucrative trading product with forced buyers, while their research departments are trying to re-invent themselves as ESG focused, as if ESG itself is a source of return as opposed to a filtering process that is in effect just another administrative layer for the fund managers. The fund managers themselves, meanwhile are aware that their large institutional clients are all now being forced to ‘embrace’ ESG are simply badging themselves as such and are simply aiming to ‘deliver performance’ (and charge for it) by comparing a fund that takes big sector risk – essentially long tech and short energy – with an index that does not.

The bottom line is that investment is about taking risk – be it benchmark risk like Woodford used to take and ESG managers now do – or liquidity risk that Woodford subsequently took and now the SPACs, Loeb and MW want to take and charge high fees for. Regulators and advisors should recognise the incentives at work and behave accordingly.

Here’s hoping.

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