Wall Street's elite flocked to Los Angeles for the 2023 Milken Institute Global Conference — Michael Milken's annual confab celebrating capitalism — but the mood was sober as investors grappled with a host of old and new worries.
Pension funds and other institutional investors at the conference, held April 30-May 3, are weighing geopolitical risks of war in Ukraine, mounting tensions between the U.S. and China, and worries that a highly polarized Congress won't ink a last-minute deal raising the U.S. debt ceiling.
The era of easy money clearly ended in 2022, illustrated by successive bank failures in 2023, starting with Silicon Valley Bank, then Signature Bank and the seizure of First Republic Bank. Market volatility is expected to continue through 2023, and pension funds are positioning themselves to pivot from traditional allocations that worked in past decades, but failed to deliver returns last year.
Worrying about geopolitics: Nicole Musicco, chief investment officer of CalPERS, shared her thinking about the fallout of U.S. regional bank failures and the impact on the future of investing for pension funds such as the $456.7 billion California giant she oversees.
"We need to think broadly about how we prepare ourselves to pivot. We manage a large pool (of assets) that's pretty much passive. For some time now we've been a passive investor, so we're thinking about knock-on effects of regional banks, the impact of geopolitical issues. I need to make sure we're prepared to pivot," Ms. Musicco said on a panel.
"We've had an asset allocation mindset historically that's broken now. So I need to look across asset classes and ask, where am I going to find yield? We've been heavy in buyout, maybe we need to pivot differently."
Emmanuel "Manny" Roman, CEO of PIMCO, said his main worry is geopolitical risks or external events that markets won't see coming.
"What we've never seen before is political pressure on China and tension around globalization. These will impact inflation and trade for the next 10 years," he said. "That's worrying."
Private markets go retail: Retail investors will be private capital asset classes' funding source of the future, but more capital could mean lower returns, panelists said May 2.
Retail investors "will probably drive returns down over time," said Jase Auby, CIO of the $179.3 billion Texas Teacher Retirement System, Austin.
David Layton, CEO of Partners Group, said more than 30% of the firm's assets are from retail investors, which is a big shift. In 10 years, retail will be the "future funding source" for the private markets asset classes, he added.
TCW braces for recession: TCW Group President and CEO Katie Koch said the global asset management firm is bracing for a "medium to hard recession," stemming from rapidly declining U.S. money supply and turmoil in banking that will hurt small business.
The failures of Silicon Valley Bank, Signature Bank and First Republic Bank will reverberate in the weeks and months to come, deepening a crisis of confidence among depositors who will end up fleeing smaller regional banks for bigger banks, Ms. Koch said.
Consequently, "there will be a lot of job destruction in general but mostly among small businesses, which are highly dependent on small regional banks," Ms. Koch said in an interview.
"We are seeing M2 growth with the greatest contraction since the Great Depression." Money supply, measured by M2, sums up currency, coins and savings deposits held by banks, balances in retail money-market funds and more.
Ms. Koch, who started at the $215 billion TCW in February, said there are opportunities during these volatile environments.
"We are looking to extend our leadership position in the leverage finance and credit alternatives market," she said. In April, TCW entered a strategic partnership with Lakemore Partners Ltd., a leading private credit investment firm primarily investing in super-majority control collateralized loan obligation equity, to support the growth of TCW's CLO platform.
She plans to "internationalize our business" by building out TCW's global presence in Asia and Europe. "We're laying the groundwork and foundation for the next generation, so I'm excited about that as well," Ms. Koch said.
VC firms face change: Venture capital firms are going through a reset that will produce massive change in the industry, in which asset owners are not only capital sources but partners, said speakers on a panel May 1.
Fundraising has fallen dramatically, noted Jamie W. Montgomery, co-founder and managing partner of venture capital firm March Capital.
PitchBook estimates venture capital fundraising could be down 73% in 2023, the lowest since 2017.
"Capital is available," said Ibrahim Ajami, head of ventures at Mubadala Capital, the wholly owned asset management subsidiary of Mubadala Investment Co., a $284 billion sovereign wealth fund.
Mubadala is leveraging the resources of a sovereign wealth fund to work with founders to build companies and has invested in over 100 companies.
"Investors are more sophisticated," he said. Venture capital is evolving and the big question now is where it goes from here, Mr. Ajami said.
Sovereign wealth funds are key to the next chapter of venture capital, he said.
What also has to change is venture capital firms need to focus more on being "very, very good money managers" that deliver consistent returns over longer periods of time rather than an industry that promises very high returns, Mr. Ajami said.
Those very high returns no longer exist, he said.
Asset owners are looking for consistency of strategy and consistency of return and whether they can work with the managers to make direct investments and co-investments, Mr. Ajami said.
"We're not interested in supporting a one-fund or a two-fund manager," he said.
"We are definitely a lot more focused on the (portfolio company's) path for profitability," said Anu Duggal, founding partner of Female Founders Fund, a venture capital firm.
"We are not looking necessarily at businesses that will grow through paid acquisitions … that model was very pervasive for a long period of time," Ms. Duggal said.
Mark-to-market woes: Pension funds and their underlying money managers are grappling with how to mark to market their private holdings.
Molly Murphy, chief investment officer of Orange County Employees Retirement System, said lack of transparency surrounding private equity and other private markets funds is becoming more of an issue for investors, and they are asking tough questions of their underlying fund managers.
"As an allocator, we vote with our feet at the end of the day. We are seeing the same asset in two different portfolios. We see it marked one way in one and another way in the other. We ask questions. We see them trade from sponsor to sponsor. We ask about why they're selling."
At the point of sale, when private equity funds sell assets, "we see realizations come under marks and ask, 'why were you so aggressively marked?' We're asking all those questions. Those who aren't intellectually honest will lose their capital base. It won't happen instantly, but end investors will lose confidence."
Jeff Aronson, co-founder and managing principal, Centerbridge Partners, said the method of accounting for private equity and private markets needs to be standardized to bring confidence doing mark to market for illiquid assets.
"You have to consistently apply" the methodology of marking a portfolio, he said. "Clients need to understand what they're investing in."
"This is not a new issue in the private equity world. Since the development of PE as a large asset class, there have been multiple instances over the past 30 years with severe downdrafts in markets, and someone could raise the same question. If they see the discrepancy, they'll act with their feet."
He suspects there will be a shakeout among managers.
"The best managers, their valuation policies, comport with reality. A subset … not so great. We haven't seen that yet. We've been in 15 straight years of forgiving public markets"
PE's democratization: Pension funds, endowments and foundations are re-examining their private equity and private market allocations closely, said Kim Lew, president and CEO of Columbia Investment Management Co.
Now that private equity is becoming "democratized" and available to retail investors, "Institutions want to know, will this asset class provide the return and diversification? We were willing to pay for the price of illiquidity" with high fees for private equity funds, Ms. Lew said. "What happens when it's no longer an illiquid asset class? What is the new role this plays in our portfolio? Do we have to look elsewhere?"
There were asset classes that were super inefficient at one point, she said. "Equities are now super efficient. PE is going the same way."
At one time, she said, "we had a bond portfolio as a diversifier vs. equities. It didn't happen last year." In addition, foundations and endowments are struggling with the denominator effect – whereby the losses in the public have reduced investors' ability to commit more money to private asset classes.
Also, private equity firms have yet to cut the hurdle rates from a blended rate of 5%, over which they charge a performance fee. She'd like to see those hurdle rates raised along with the predominant interest rates today.
"Hurdle rates back in the day were 8 to 9%, and the argument made (to limited partners such as her firm) was it should be dropped to 5%. That's when rates were lower. The agreement was, how much should you beat it by to be very good at this? That's the struggle LPs are working through. What was promised and what's the expectation now? It stems from the idea that the pendulum never swings back. What's the rate at which it feels worth paying for" to invest in a private equity or private asset fund.
Sometimes portfolio managers "think they're Bo Jackson who can do two sports. And really they're Michael Jordan and they should stick to basketball ... but they want to give us the same check" for the same strategy. "By the way, I love you, Michael Jordan," Ms. Lew said.
