EUROZONE: The world according to Marks

There is a new finance book making the rounds in the London office of PERE.  It is a first-run copy of The Most Important Thing by Howard Marks, the chairman and co-founder of Oaktree Capital Management, a Los Angeles-based private equity firm with $80 billion in assets.

Given the book has been written from the vantage point of a lifetime’s worth of investing, it is unsurprising that it contains many gems of ‘uncommon sense’. However, page 179 is my personal favourite.

In the last chapter, entitled “Pulling It All Together,” Marks writes: “Neither defensive investors who limit their losses in a decline nor aggressive investors with substantial gains in a rising market have proved they possess skill. For us to conclude that investors truly add value, we have to see how they perform in environments to which their style isn’t particularly well suited.”

That got me thinking, and it should get every private equity real estate firm thinking as well. Is your firm suited for this environment?

It didn’t occur to me at the time, but that theme was kind of in the background at the PERE Forum: Europe last month. You see, having gathered together 300 delegates to speak primarily about opportunistic and value-added investing, the undercurrent was that this is a time of great uncertainty in Europe. Among the issues causing uncertainty: Greece, banks, regulation, investors and income.

Taking Greece first, there still is the threat of a sovereign debt crisis on the horizon. Ultimately, such an event could cause a wholesale real estate price adjustment.

As for banks, it is unknown exactly how things will pan out, but there are two possibilities. The first scenario sees banks doing what many investors have been hoping for and selling their distressed loans wholesale. However, that could end up flooding the market and causing a price readjustment, given that the numbers are so big. Indeed, there are about €380 billion of nonperforming loans held by Europe’s banks. The other possibility is the banks won’t sell much and consequently won’t lend much either.

With regard to regulation, the combined effect of the European Market Infrastructure Regulation, the Alternative Investment Fund Managers directive, carry limitations and so on cannot be overlooked. Still, those rules are not that well defined even now, and some may yet be subject to change.

On the subject of investors, some say they are going back up the risk curve, but their actions say differently. Most still seem to predominantly like core assets, and big beasts like AP1 and AP2 of Sweden are going direct. Many seem to prefer the US and Asia as markets, and they don’t really seem to be going for 2 and 20 as a model either. Will that change?

Lastly, there is the issue of income. As IPD’s Dr Ian Cullen said at the Forum, the trend is going away from capital returns to income. But if Europe is to be just a low-growth museum, how do we know rents will trend up?

Separately, these issues may be manageable, but take them together and Europe doesn’t readily sell itself as an environment suited to opportunity funds.

Again, it didn’t dawn on me at the time, but what Ralph Rosenberg of Kohlberg Kravis & Roberts said on stage at the Forum kind of makes sense given all of the above. He talked of looking at property deals that will provide a range of returns for investors from low single digits to above 20 percent. The firm isn’t saying it is going out there with an opportunity fund right away. Instead, to quote Rosenberg, it thinks its job is to be an asset manager across the spectrum for clients. “If we do that well, we’re going to get rewarded for that,” he said, adding that the firm will be opportunistic players, mezzanine debt players, value-added investors and buyers of core. That seems to be a sensible approach.

That is not to say that firms that only run opportunity funds won’t succeed, but flexibility for clients in this day and age does seem to be an advantage. Perhaps it always has been the case, but more so now than ever.

Here is another passage from Howard Marks’ book. On page 140, he writes: “Several things go together for those who view the world as an uncertain place: healthy respect for risk; awareness that we don’t know what the future holds; an understanding that the best we can do is view the future as a probability distribution and invest accordingly; insistence on defensive investing; and emphasis on avoiding pitfalls. To me that’s what thoughtful investing is all about.”

The good news is from the Forum is that those concerned primarily with opportunistic investing are putting a great deal of thought, risk assessment and patience into the art. In no sense are firms rushing through with investments. By definition, there will be winners and losers in a competitive market, but the relative slow volume of deals in Europe is at least giving teams enough time to focus properly on every aspect of responsible investing.

To refer back to Marks’ book one last time: “The most successful investors get things ‘about right’ most of the time, and that’s much better than the rest.” That’s not a bad mantra for Europe in these uncertain times.