Transcription
James Grant: The risk is considerable. Private equity has taken a keen interest in the life insurance companies.
Consuelo Mack: On WEALTHTRACK, the risks insurers face from private equity.
Narrator: Funding provided by ClearBridge Investments, the Fairholme Foundation, First Eagle Investments, Bill Miller, Miller Value Partners, Baird, Strategas Asset Management, Research Affiliates, Royce Investment Partners, Seafarer Capital Partners and Women Investing in Security and Education.
Consuelo Mack: Hello and welcome to this edition of WEALTHTRACK. I'm Consuelo Mack. Two notable events have been in the news of late. One is the problem arising in what is called private credit. That is, lending by investors to private companies that otherwise might not get financing because they are either not creditworthy or don't have access to the public debt or stock markets. The other, of course, is the celebration of the 250th anniversary of the Declaration of Independence, otherwise known as semiquincentennial of said document. That is a word that only this week's guest would use or pronounce properly, which is why I invited him on to enlighten us. He also knows a thing or two about private credit and other debt instruments. He is James Grant, financial thought leader, historian, founder and editor of Grant's Interest Rate Observer, a twice monthly journal he launched in 1983 that is widely followed by institutional investors. Grant is also the author of ten books on finance and financial history. His most recent being Friends Until the End: Edmund Burke and Charles Fox in the Age of Revolution, and another, more closely related to our American moment, is John Adams: Party of One, a biography of the second U.S. president. I began the interview with a current financial concern: the challenges faced by private equity and private credit. How worried should investors be?
James Grant: Well, we should be very concerned. Private equity to start with is bigger than all outdoors. Now how might how big might that be? Well there are let's see, there are, um, something like, uh, 14,000 McDonald's franchises in the country, 14,000 golden arches. There are like 18,000 private equity funds. There are 32,000 private equity portfolio companies. There are fewer than 5000 public companies. So this is a nation of private equity. It's a nation of private equity and private leverage, private credit. And, um, nothing wrong with that on the face of it. Um, nothing says you have to be a public company to be legitimate. But what characterizes many, if not most private equity companies or promotions is a high degree of financial leverage, which is simply trade talk for a lot of debt. The thing to know also about private equity is that it is susceptible to all the fads to which we all fall in the world of finance. We get very bullish at the top and we get very concerned at the bottom. So what happened in 2021 and '22 especially, but also a few years before, was that interest rates got very, very low and the private equity promoters became very, very bullish. When money was free, um, it was so good. Nothing like free money. Consuelo you can agree with that. And, and with this free money, private equity promoters went out and bought a lot of companies. Of course they paid top dollar because why not? It was a bull market because money was, shall we say, accessible. And they borrowed it like nothing. And when rates went up that nothing became something because importantly, they borrowed at floating rates. Almost all of them. So what we have here is an investment fad predicated upon the continuation of something that was bound to come to an end and which did indeed end, namely, the institution of free money that was part and parcel of the Fed's response to the great troubles of yesteryear. So all of this, uh, windy prologue to a very good question is that the concern is certainly appropriate. Yeah, we ought to worry.
Consuelo Mack: The numbers seem large, but in actual dollar volume and the leverage attached to them, how big a deal are they?
James Grant: Well, that too is bigger than all outdoors. The aggregate estimated market capitalization of these 30, uh, 2000 calls of private equity companies is something like 3.8 trillion with a T, and which that's according to Bain, which is a lot of money even if you say it fast.
Consuelo Mack: Is this one of those situations where it could spread rapidly and cause a real financial crisis?
James Grant: It could, of course. Um, I was previously dealing in the realm of facts. I quoted a number of golden arches in the country, the number of private equity funds. Right. I quoted the value estimate of those funds, but what I did not do was go out to them and say, well, yes, a crisis is crystallising even now. But what would cause such a crisis is the rise in short term interest rates. Uh, that is not over compensated by a rise in the earning power of those aforementioned thousands and thousands of private companies. You know, everybody in America gets up in the morning and wants to do better. And we are adaptive. And no doubt the managements of these private equity companies are themselves adaptive. There's only so much adaptation that can postpone the consequences of a bad balance sheet. By which I mean, uh, when the fixed charges that you must pay on your debt, that is the interest, even though it's floating, we call fixed when that interest bill is greater than the cash you generate to pay it, you must do a couple of things. You must slash the payroll. You must reduce capital spending. You must not go out on a limb to create a new product, because that would be imprudent given the financial circumstances of the firm. You must negotiate with the debtors. It's difficult. Certainly for me, it is impossible to pinpoint a time at which a latent crisis becomes manifest. But what I think is shaping up now in a very troublesome way, is the alignment of a pair of a very, very portentous stars. And one of those stars is as the rate of interest, short term rate of interest in the in the marketplace, and that rate of interest the Fed sets as its policy rate: Fed funds rate. That's one star and the other is the rate of inflation.
Consuelo Mack: So we are right up your alley now, Jim Grant, as the observer of all things related to interest rates, inflation, and obviously the Fed funds rate being among them. So what is your assessment of the direction of both?
James Grant: Well, I think both the inflation rate and the cost of a loan are moving in the wrong directions, wrong directions from the point of view of the borrower and not bad direction from the point of view of the creditor with respect to interest rates. But you know, the whole the country is a leveraged country. It's leveraged in the public sector. Famously, we're now paying $1 trillion a year in interest expense, and much of that is floating rate Treasury bills, notably. Also floating rate notes. And we are leveraged in the corporate sector with respect to these private equity companies that are borrowing at floating rates. And we are leveraged at home with respect to floating rate mortgages. So we are as a nation, America is that is very sensitive to interest rates and also very sensitive to inflation. This business about affordability has become a national hue and cry. You know, the visiting Martian would not necessarily expect this degree of political animosity based upon the published rate of inflation. It is an act in Congress that's being talked about. The Affordability Act, whatever they want to do is not going to be good. The president already has begun intervening, as is his want. You know, this Republican is wants to cap credit card fees and and tell companies what they can charge for this and that. So private, uh, equity and private credit and inflation are converging in ways that are, I think, potentially very troublesome.
Consuelo Mack: And to whom in particular, are they particularly troublesome?
James Grant: It's a universal concern. Uh, every viewer of this, of your fine show Consuelo owns something in the way of a balance sheet asset. Most Americans either own something or aspire to own something we can put on a balance sheet, so that the population of stock holding Americans is very high. Similarly, with population of debt holding Americans, bond buyers and investors and treasuries and the like, people who buy gasoline for their automobiles, that population is legion. This is a a latent crisis that is becoming, I think manifest is is is crystallizing and it affects almost each and every one of us.
Consuelo Mack: One of the industries that you've written about in Grant's Interest Rate Observer, in relation to the challenges facing private equity are insurance companies. How much of a risk is their exposure to private equity?
James Grant: And the risk is considerable. Private equity has taken a keen interest in the life insurance companies, and not a few life companies are under the ownership of private equity sponsors and private equity promoters. So what do you do if you are a private equity company and you have in your possession a life insurance company? Why do you use that to house investments that you think are either creditworthy, or you want to get off your own books and put someplace? These life insurance companies, I think I have read, in fact, I'm reading it right now, they held $1.8 trillion worth of private credit at the last count, 1.8 trillion.
Consuelo Mack: In their portfolios, in their insurance portfolios.
James Grant: Almost, but not quite half of their credit portfolios. So, um, so already, you know, the, uh, the life insurance business is heavily invested in, in this great big fad of private credit. I say fad because I think it, it's a characteristic characteristic of Wall Street enthusiasm that's been carried too far. So the trouble with this, Consuelo, is that a life insurance company is not a bank. There is no FDIC for the life insurance industry. They're regulated, these companies are, by states and state insurance commissions. Uh, many of them, uh, do have protocols for assisting a life company that runs into financial trouble. But typically the amount that an annuitant or a policyholder can, can redeem can get restitution is like a, a quarter to a half million dollars. There's no FDIC. There's no, uh, national regulatory body, which I think is both perhaps in some ways a good thing. Um, states ought to have some power over these things, but that's not necessarily a thing that is going to protect against a nationwide problem if such develops. Now, suspicion that a nationwide problem could develop is evident because Scott Bessent, the Secretary of the Treasury, recently sat down with a bunch of state insurance commissioners to inquire of them, just what do you know about this risk, and what do you propose to do about it? This is one of these quiet things that may come to nothing, but I think it's going to come to something. And I think that it behooves everyone who has a life insurance policy of significant size, for that individual ought to be in touch with the financial advisor, if you have one, or just as your own eyeballs and see about the ownership of this company.
Consuelo Mack: Right...
James Grant: Is it a subsidiary of a private equity company? If it is, I think that you ought to dig further and decide whether you want to be at risk of that particular balance sheet and that particular management style. We happen to like and regard as a model of fiduciary management and responsibility New York Life as a life insurer.
Consuelo Mack: It's one of the oldest.
James Grant: So yeah, one of the oldest and I think one of the most conservative. And that's as far as I care to go in naming names, to name a good one.
Consuelo Mack: Jim, are you personally doing anything with your investments in response to this danger that we, the general public, are just learning about?
James Grant: It won't surprise you to learn Consuelo that I am somewhat conservatively invested as a matter of course. There are ways that one can take a position in this to protect against individual names. Some of these live companies are publicly traded. One could take a short position, and some of the ones we have identified as risks have already underperformed the indices substantially. I would not recommend short selling as a as a vocation, let alone an avocation. I think I have declared in the show, perhaps to the extent that people would rather not hear it again, I own gold bullion and gold mining shares. I believe that gold is going to be a monetary asset of even greater value come the crystallization of the many credit risks I see forming around us. I am a limited partner in some funds that seek to find safety in what the value tribe calls a margin of safety by looking for deep value that is likely to hold up in the case of trouble elsewhere. And as you have observed to me, the siren call of deep value has been a very unprofitable one all these many years. I guess I'm kind of stuck in Graham and Doddsville.
James Grant: But my approach to this is to have enough liquidity so that you can opportunistically present yourself to the marketplace to take advantage of what might be flawless. All. And it suggests that it will. Or to state that it will. It's nothing radical. We are a cyclical world. We. World of market people. It's as sure as can be that a great enthusiasm for private credit is going to result in a bear market in all credit. You can see it in the quality, deterioration, in the quality of underwriting. You can see it in the deterioration in the quality of the fine print that used to present a degree of protection against lenders. You can see it in the proclivity of these private equity partnerships to overpay for business during the fine old high cotton days of early 2020s. So all this is aligning to what is almost bound to be, I think... I say at most humbly, as somebody who fervently believes the future is a closed book. But I would be astounded if there were not a down cycle to our credit operations. Having been having been so long in a bubble environment. On the upside.
Consuelo Mack: I'm going to turn our topic to one of your favorite conversation pieces, and that is history.
James Grant: Ah, yes.
Consuelo Mack: You you wrote a wonderful article in the Free Press, and it is The Men Who Bankrolled America. And I think one of your opening lines was the founding capitalists have not been given their due. So who were the founding capitalists that we should be celebrating as we are in the semiquinten session? Wait a minute. Semiquincentennial of the Declaration of Independence. I got that word, Jim, from your article in the Free Press, The Men Who Bankrolled America.
James Grant: Well, you know, I can spell it, but I can't say it. But in the 250th anniversary of the signing. Okay, so the Free Press said, tell us about the the neglected capitalists of our independence. And I chose Robert Morris as one. He was a revolutionary era financier. They called him the financier, who was, among other things, personally so funny and charming and and of course, capable. My goodness. He was America's largest ship owner for a time. He was one of the great real estate speculators in America. For a time. In fact, it would cost him his fortune. He got leveraged. And long as sometimes happened in real estate, never mind that happens. But in the meantime, at great personal risk and at great personal generosity financed George Washington armies, not least on the eve of the decisive American victory at Yorktown. And another man named Morris was a Gouverneur Morris, whose first name also, uh, kind of defies accurate spelling the first couple of attempts. I've just bought his, uh, collection of his correspondence, and he's such a funny man this Gouverneur Morris. And also, he said he he held many positions in the revolutionary era and was regarded as the great stylist of the Constitutional Convention. He was the penman. And here's what Gouverneur Morris said about his public career. He said, I have never sought public office, never refused it, and never resigned from it. And isn't that a noble thing to be able to say? And one of the things that draws me to this, that era, John Adams, I should mention as well, he's a favorite biographical subject of mine.
Consuelo Mack: Right, John Adams: Party of One, which is a biography of John Adams that you wrote.
James Grant: Yeah, I did. And the publisher said, are you sure you want to name it Party of One? Some of the people here are thinking it might refer to a restaurant reservation. I said, no, it's... It's John Adams's bloody mindedness. He couldn't be a party of more than one person.
Consuelo Mack: No, I thought it was a great title.
James Grant: So anyway, so John Adams, one of my favourite people, living or dead, was himself a most, you know, irrepressibly assiduous seeker of borrowed money for the Revolution. It was a great part of America's first international junk bond sales when he prevailed upon the court of France and the skinflints in Holland to lend America money, although we were certainly then a junk credit, junk em credit emerging market credit. I was glad to be asked for this piece, and I was glad to be able, with my limited powers, to point a spotlight at the most deserving capitalists that I'm aware of in America.
Consuelo Mack: What did the founding capitalists get right, Jim?
James Grant: What they got right was the vision of a great country. I am such a sucker for this. I get goosebumps when I read the things they enjoy. I took it to the extreme of I forgot what city in Pennsylvania, he said, would come to to rival Paris, not Philadelphia, but the city in Pennsylvania that the Continental Congress, uh, once made its headquarters at. And it was someplace that not everyone would want to go on vacation in lieu of Paris. But let me just say that the John Adams's vision of America encompassed the belief that this particular city in Pennsylvania, no doubt many of your viewers will know, would one day, uh, overshadow the City of Light, Paris. I think that was just marvelous. I read that and I sort of laughed and laughed. I thought, yeah, that's what he thought. And the point survived the exaggeration.
Consuelo Mack: But what's, I think amazing is that the the structure that these founding capitalists built for America have lasted as long as they have under the assaults that they have come under.
James Grant: Well, the foundational beliefs, even, I think perhaps as foundational, certainly perhaps a little more so is the is the right to one's property and to the rule of law, to the equality of everyone under the law. Those two things we've taken for granted until the government, as is its want, sometimes steps on the toes of us citizens, and we say, ah, let's have a little judicial review of this overreach.
Consuelo Mack: So one investment for a long term diversified portfolio, Jim Grant?
James Grant: One of your recent guests, Matt McLennan, said it very well. He said gold is his monetary base, which I think is a great and charming phrase for what he regards as the role of gold in a portfolio. It's part of a well tempered or well conceived portfolio. What seems to me... It is money, that kind which the government, try as it might, can't depreciate as it does with our paper. The Fed is in business to depreciate by 2% a year. It's rather doing more than that now. So you know. And gold, you wouldn't think it would do that well, because it is just money. It earns no interest. It's not going to go up on you. And because of a takeover, your goal is not going to get absorbed by some private equity promoter. But lo and behold, has outperformed stocks over 25 years and over 15 years, over five years. So there's something in it... I think the world is twigging on to the fact there's something in it. And that is my nomination.
Consuelo Mack: Jim Grant, thank you so much for joining us once again on WEALTHTRACK.
James Grant: Oh, Consuelo, you are so welcome. What a pleasure it has been!
Consuelo Mack: At the close of every WEALTHTRACK, we try to give you one suggestion to help you build and protect your wealth over the long term. We have asked Jim Grant to help us out by identifying a key characteristic of successful investors. This week's action point is be an independent thinker.
James Grant: I'm going to quote the brother of an investor of mine. The brother's name is Joe Robillard, Biff's brother. And we've adopted this this advice for our own corporate slogan. And it is this: successful investing, Consuelo, is about having everyone agree with you... later.
Consuelo Mack: That is a great slogan. So how do I get to the point? How does a an investor get to the point where he is or she is actually, uh, has made an investment that everybody agrees with later?
James Grant: To have everyone agree with you later means that few agree with you now, which is a way of saying that your choice is so contrary, so, uh, out of the mainstream and perhaps for that reason, so cheap and accessible that it is, on its face, a good investment. And with the validation of that analysis or hunch over the course of years, perhaps, or indeed, in my case, with regard to gold over the course of many decades, people will say, well, that wasn't so stupid.
Consuelo Mack: So contrarianism... Against the herd.
James Grant: Yes, but not for the sake of being contrarian. Just because you walk outside and everyone's got an umbrella doesn't mean it's not raining. This is a kind of a conceit that comes with the pursuit of contrarian ideas for their own sake. One must be careful about it. But, uh, things that are wildly popular are rarely good investments for the long term. But by definition, because, uh, they are overpriced because everyone owns them, because they're popular, because they're faddish, you know, obscurity is not necessarily is not this positively the precondition to a successful investment. But it is... It is certainly an indicative sign that you might be onto something.
Consuelo Mack: Advice from Jim Grant, a source of independent contrarian thinking in his own right and one of the best observers of investors and markets out there. We are looking ahead here in WEALTHTRACK. After next week, we will be transitioning to a podcast format only. So next week will be the final episode of WEALTHTRACK on public television. And we have a great guest for you, part two of our interview with superstar investor David Giroux. He is celebrating 20 years of running the award winning T Rowe Price Capital Appreciation Fund, and he has some great investment lessons to share with us. Feel free to follow us on Facebook, X and our YouTube channel. Thanks for watching. Have a happy Father's Day weekend and cherish your dad. I miss mine every day. Please make the week ahead a healthy, profitable and productive one.