Toddlers are notorious for scrapes, cuts and bruises. They run without looking and hit a tree or trip over a toy. Tears and possibly a tantrum are next but eventually a lesson is learned. It’s easy to make an analogy between toddlers and financial market participants. They both scream a lot; “I want” is a common phrase and they have their ups and downs but there is one big difference. The toddler eventually learns to avoid the things that make him fall down but the financial market participants don’t.
We have just gone through several years of some tough lessons in the financial markets. Here are a few: Don’t give credit to high risk entities without some measure of control when things go wrong. When everyone else is jumping in, it’s probably a good time to jump out. Yet, in the leveraged loan market, we seem to be steadily making our way back to the loose lending practices of pre 2007 while the private equity investors driving this are paying too much for many of their investments.
While it sounds crazy, it makes a lot of sense in the context of how the private equity markets work. As the Economist highlighted last week, private equity firms don’t have a choice. They have a bunch of cash sitting around that they need to invest. If they don’t invest it, they don’t earn their carry and even worse, they may not be able to raise another fund when the current one matures. With regard to the investors who are buying the highly leveraged debt with loose covenants off the back of these LBOs, they are in a similar situation. They have to invest in something that has a return. With interest rates where they are today, fixed income investors are back to searching for yield, the catch phrase of the pre-crisis market.
Contrary to the implication of the Economist article, it is not about the lack of institutional memory or the fact that lessons weren’t learned from the credit crisis, it is the rational behaviour of individuals who are performing as they are incentivized. Of course, none of this is a surprise. The LBO/Leveraged Loan market has boomed and busted several times in the past and it will likely do so again. The relative size of this market is such that we are generally entertained by the headlines and rarely see it as a source of concern. However, given that it represents a little microcosm of the larger financial market, isn’t it a good time to analyze the incentives implicit and explicit in the risk decision making process and identify how we might mitigate the pro-cyclical nature of financial market behaviour generally?