“A long-term investor sells when it wants to, not because it has to.” This is an especially clear and succinct definition of long-term investing. Long-term investing is about how the institution behaves, not a fixed time period.
The Silicon Valley Bank collapse provides an object lesson.
We have seen crises arise twice over the past six months in seemingly long-term portions of the market: UK pensions, whose funding levels far exceed those in the US; and now in the SVB-banked private equity community, whose partnership agreements commonly extend to seven years or longer. The same underlying behavior led these ostensibly long-term institutions astray. Each took an uncompensated – perhaps even unknown – bet that public-debt trading would remain within a manageable range of those bonds’ terminal value.
To put it plainly, they may have had strong plans for how to thrive in the long run but overlooked what it would take to survive along the way.
Emergency action by the FDIC is now the only thing standing in the way of businesses backed by private equity being stopped out, which undoubtedly would ripple through GPs’ performance and LPs’ asset allocation. These institutions mean to outperform public markets over decades and catalyze the next generation of innovation, including addressing societal urgencies like mitigating climate change.
But they failed to notice that their banks could not meet their portfolio companies’ withdrawals without a fire sale of public debt holdings if interest rates were to rise – as they have for the past year.
In the same vein, the UK government had to offer emergency accommodations last fall when pension investors neglected to notice something similar. In the interest of smoothing their short-term performance on paper, pensions throughout the UK took derivative positions in the public debt market, but without the liquidity to cover capital calls that would result from the same sorts of interest rate increases.
Paradoxically, focusing only on the long term is one of the most devilish short-term behaviors. It nearly collapsed these institutions, and the regional banking crisis is still unfolding in the US. They missed the first step of long-term behavior: be ready to survive the short term.
Perhaps intuitively, many mistake the short term as merely a piece of the long term and assume that optimizing for the long term means being in a position to succeed in each smaller time period within it. False. The long term is not just a series of short terms.
Think about it like a flight. All else equal – same model airplane, for instance – are you more likely to encounter turbulence on a quick hop between nearby cities or on a transoceanic haul? It’s the latter, of course. The transoceanic flight will cross through a wider variety of atmospheric conditions, just like the long-term investor will encounter a wider variety of market conditions.
Many will claim that these rate-related crises were still unforeseeable. Who could have expected that higher interest rates would hurt pensions, when all the ordinary evidence is that they help – or that these rates would matter at all for short-term liquidity in private markets?
These claims are being made by those who misunderstand the risks being encountered. Rates are merely instrumental. These crises really are about some market participants failing to anticipate or appreciate the foreseeable behavior of other market participants. In other words, it is counterparty risk flavored by specific circumstances.
It is the risk of expecting other people to behave like cold, rational computer models instead of panicked humans who do things like run banks or cover derivative positions by realizing long-term holdings.
Richard Bookstaber writes about this exact dynamic in The End of Theory, drawing on his hard-earned scars from the 2008-09 crisis. The gist is that, when people around you in the market act in ways that surprise you, you can surprise yourself in how you respond. Surprise in this sense is never good and always short-term. It is selling assets when you must, not when you choose.
Long-term investing now sounds a lot harder. No one intends to sell before they want to. But it happens because the only way to avoid it is by anticipating the market behaviors of everyone around you, as well as your own. Long-term investing is realizing that you too can panic – and then putting systems in place beforehand so that you don’t.
Matthew Leatherman is managing director, programs, for FCLTGlobal