Market Risks and Alternative Assets

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In today's post, we're inspired by our interview with Kevin Lester, co-founder and CEO of Validus Risk Management, a specialist financial risk advisory firm with offices in London and Toronto. With a focus on the alternative asset management sector, Kevin has pioneered the use of innovative financial hedging tools and techniques in the private equity, private credit, infrastructure and real estate markets, and is responsible for managing over $300 billion in market risk exposure via the Validus platform.

Connecting Private Equity and Risk

 

About a decade ago market risk was a relatively unexplored space within risk management. At this time, risk management was seen as a cost center. It was certainly time to move it into becoming a revenue generator. One way was to the emergence of the private capital space as a market. It was still relatively large at that time, it was growing very rapidly and it has since grown a huge amount. As it was a bit of an unplowed field, there was no consensus as to what practice there was to some extent, a desire just to bury your head in the sand and not worry about it. 

 

Within the private equity world or the private capital world, hedging was not something that was well known. There was also a little bit of a reluctance to actually engage in a risk management activity as you would see in banks or hedge funds or even in the corporate world.  Essentially, this field became what it is now with a lot of talks and discussions with the people in the industry, and involvement of academia - which up to this point was quite neglected.  Interestingly, the private capital markets, it’s a $7.5 trillion market now, it’s still relatively underserved. And for that reason, it’s intellectually stimulating as well as a really great business opportunity.

Setting up a Successful Business in the Risk Industry

Being an entrepreneur in the risk field can be a bit of an abstract concept. As an entrepreneur and someone trying to build a business in Risk, one of the struggles is sitting in front of the potential client and trying to sell a risk management service, one of the challenges you have is an abstract concept. Because if you put your risk management hat on, very few people are going to go on to start a business because you are taking on so much uncertainty, volatility and risk. Being a risk management entrepreneur might be a strange position to be in, but  there are few important things to pay attention to.


Practicality is a huge factor into success. Instead of becoming a typical consultant or advisory firm that will come in and cope with lots of great ideas and then walk away and allow the client to take it from there. Accordingly, going one step further than your competitors and what your client really wants is the most crucial step as with any other industry. For example, In Kevin's case, also providing the technology for the client as well as monitoring and reporting on their hedging portfolio was their method and also long-term solution. There is no point in designing a strategy, which theoretically looks great, or it might look great on paper, but when you try and take it to the market, it either doesn’t work or has all kinds of unforeseen secondary or tertiary effects.

Second step is focusing on a very specific and right target group. In the case of (market) risks focusing on private capital managers, investors, private equity fund executives, pension funds and so on are various options. Once you pick your target group, your strategies and service must be designed uniquely and customized to the needs of them. Similar target groups will still present opportunities however, so you are not limited to a very small market in the end. For example, a typical private equity fund would not really be concerned about short-term volatility, as they don’t look at things like Sharp ratios. They have their own kind of lexicon of how they approach performance, including Risk. So you'd need to look at  what’s the risk to your multiple or to your IRR, as opposed to just giving them a VAR number.

Volatility and Market Risk

The role of volatility is a big misconception in the market risk industry. In conventional financial risk management, there’s a tendency to equate Volatility and Risk as being almost the same thing. Whereas, not only that they are not the same at all, but in some cases they’re actually opposites and there’s a great quote by Nassim Taylor that you can’t have long-term stability without short-term volatility.  Volatility has a lot of far reaching consequences, both in terms of the macro environment and micro-managing markets.

In the currency world, you could even look at something like the Euro. The one of the main arguments in favor of the Euro was to minimize trading friction by minimizing currency volatility for trading within the Eurozone, but that had lots of unforeseen consequences. Although, for some countries that was a good decision, for others, it created certain obstacles to economic management and then on a micro level. You see the same thing in assets which are very stable, but what’s really happening as risk is just being compressed and compressed and compressed until it blows up and. A really good example would be Swiss Frank a few years ago, where for three years it barely moved around 1.20 and then in one day it declined by over 40%. Because all that risk was being compressed and it was being hidden in effect because if you looked at the volatility alone, you wouldn't see much risk whereas in reality there was a lot of risk and some firms blew up with real serious world consequences.

This of course doesn't mean that volatility is  useless as a measure. Risk managers use it every day when they are looking at measuring risk for their clients. But the key is to first of all to understand the weaknesses and second of all, to not look at it as an absolute measure of risk. It’s one input, it does provide some informational value, but if you’re not careful, it can be misleading.

Do's and Don't Do's of Risk Management on Market Risk Industry

Particularly in market risk, risk managers should be thinking more strategically, in terms of business strategy of the investments. If you look at risk in a siloed way and you don’t try to relate it to the objectives of the business or to the objectives of the investor, risk management can go wrong or at least not add the value that it potentially could. Risk managers should think more like business owners or investors themselves and not get too compartmentalised in all of the technicalities of risk management.

On the flip side, risk managers are focusing too much on the models, and not necessarily in the big picture. According to Kevin, risk management is an interesting blend of art and science. Within the broad risk management field, there’s too much focus on the science piece and not enough on the art. Risk managers are getting too focused on the models, getting the models right, getting the precision of the models and not enough focus on the bigger picture and contextualizing what they’re doing. Risk management is always in real time - and not in a vacuum. With the amount of unpredictability just applying the same techniques, the same approach is the same way of measuring risk and ignoring the background, ignoring the context is something risk managers should stop doing. 

Thoughts on Current USA Market and Predictions

It’s a huge factor as a risk manager to try and understand what’s happening and more importantly what could happen. From a monetary policy standpoint, we are in a very interesting time. Although we can't exactly know what is going to happen, we can make educated predictions. Currently, there are very interesting occurrences in markets, whether it’s crypto or things like SPACs. Just general valuations, in the private equity world we’re seeing multiples of 40% higher than they were a decade ago. So you’re paying 40% more for your EBITDA than you were a decade ago. Kevin mentions that on their market outlook discussions for 2021 they saw three possible scenarios for the markets:

The first one is a benign reflation, which was pretty much the consensus view where there’s going to be in the back of the vaccines and the fiscal and monetary support, we might see a recovery in markets and the Central Banks would be able to control the inflation and keep a handle on that. 

The second outcome is what we call the market meltdown, which was a big correction against all of these valuations. This however, is not a likely outcome simply because of the degree of monetary and fiscal support that had already happened and it was almost certainly going to continue.

And then the third scenario is the market melt up, which is similar to the benign reflation, except that the Central Bank isn’t able to control inflation. This is where you would start to see all kinds of side effects of monetary policy spilling over, ultimately into inflation, but also rates pushing higher. A quarter over of the year later, Kevin's probabilities have shifted a little bit more towards the market melt up scenario.

Crypto is also a really important factor to focus on from a macro perspective in terms of what it means for the monetary system. The crypto trade in some ways is a shortcoming of the current monetary system. It’s an expression of distrust. And if that distrust builds too far, it’s going to affect everything else. So, that's one important reason to focus on crypto and the other reason is that it has become, now a systemically important asset class in its own right. When we are looking at a market cap of crypto, well over a trillion, we see institutional investors starting to get into crypto as well. Although it’s very embryonic at this stage, in the foreseeable future it will highly affect the other assets.

In any case whether you want to pick crypto, or other assets, there are big movements. For example, the lumber prices are up 400%, house prices in the US are up close to 20% year on year. Seeing these numbers, there's a probability that the Central Banking fraternity is going to struggle to control what they’ve unleashed. And that is going to have knock on effects across the markets, whether it’s in our world, currencies, rates and commodities, but also equities and so on. This is not to say that we’re going to see double digit inflation in the next year but we might see high numbers, and that’s going to have some knock on effect across the market.

Closing Words

For now, this sums up the key points of our interview. As the Global Risk Community team, we once again thank Kevin Lester for his insight on market risk and alternative assets. More information about this topic is available in our original interview, which is accessible here.

#risk #market #finance #equity #investment

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