On this episode of The Long View, Brian Selmo, portfolio manager and research director at First Pacific Advisors, discusses his perspective on market volatility and uncertainty, opportunities for investors globally, how he is thinking about AI, and how the expansion of private markets could affect public markets.
Here are a few excerpts from Selmo‘s conversation with Morningstar’s Dan Lefkovitz.
How Fund Managers Are Balancing Different Levels of Liquidity of Private Market Assets
Dan Lefkovitz: I want to shift gears and talk a little bit about private markets, which is a very hot topic these days in the investment world. There’s a lot of efforts to broaden access to smaller investors. You’ve owned private companies and private debt for many years now. I wonder if you could share your approach to private assets?
Brian Selmo: Yeah, for sure. From an analytic perspective, it’s really the same. You have a different level of liquidity. I think the big positives are, if we’re talking about companies, and if you are able to be in a control position, you have control ultimately over the management, the use of discretionary cash, and strategy. You can meaningfully reduce the principal agent challenges that you often have in public markets. That’s not to say there aren’t many, many public companies where I probably think the governance and behavior of management is better than it is in private companies. There’s also a lot of challenge if the nature of the people running the public companies aren’t shareholder-oriented. It’s very hard to change them. That’s the big benefit, I think, of being private. As a manager the real issue is around matching the liquidity of the investment to the liquidity of the assets of a fund that are holding it. In Crescent, which is an open-ended fund, we have very, very little appetite for privates because it’s a daily dealing fund. Now, we also manage a closed-end fund called Source. Source has a large appetite relative to its size for privates. It’s actually significantly invested in private credit as well as some private equity these days. I think that will continue because Source is essentially a locked-up vehicle. It’s an appropriate profile to own illiquid assets. In Crescent, we have invested in privates over time, but these are private or illiquid. I would put quotation marks around really from an SEC definition perspective rather than what I think of as in practice, genuinely illiquid or private. The reason for that is the two big exposures we’ve had there is one—we bought pools of defaulted mortgages after the financial crisis. These were pools where we were the 100% owner of the assets, so we could choose to dispose of it when and how we would like. They were self-liquidating, so they were pretty liquid even though they didn’t have a CUSIP and trade. Then over the last 12 years or so, we’ve been investing opportunistically in ships in a number of different sectors within shipping. We’ve got some partners who manage the buying and selling and operating of the vessels, but we’re over 95% of the capital, and we can determine when and if we buy or when we sell. Ships are actually fairly liquid as an asset. They trade pretty regularly, and so we can exit our ships, I think, over no more than 60 days if we’ve needed to sell. That although it shows up as private or illiquid, it’s actually probably more liquid than, call it, a huge stake in a small- or mid-cap company.
Are There Signs of Froth in Private Equity and Private Credit?
Lefkovitz: I’m curious with all of the institutions increasing their allocations to private equity and private credit, have you seen signs of froth in either asset class?
Selmo: It’s a good question, and people have been talking about it for a while. I don’t know that I am deeply enough involved in those markets to really comment. I think we don’t see that … You know, AI-backed venture firms are getting money, it seems like left, right, and center at very, very high apparent valuations given neither the number of people involved or how long the business has been around, but that’s the nature of a big gold rush around an interesting opportunity set. Whether that all proves to be a smart idea or a bad idea, I think it’s way too early to tell. On terms of the private equity, call it, traditional buying of mid-cap businesses, I think that’s a market that’s cooled a lot in the last three years or so. During covid, when rates were at zero, I think people were buying, it seemed to be, that people were buying any decent business that would trade. Now, I think that that private equity bid is much subdued. I’m not sure that I have a blanket statement on it.
Why Banks Are in a Safer Position Today Than They Were Before the 2008 Financial Crisis
Lefkovitz: The common story with private credit is that increased regulation on banks after the financial crisis curtailed bank lending and gave rise to private credit. It’d be interesting to get your perspective on that, especially because you own some big US banks.
Selmo: Yeah, look, I think that’s dead right. I think that we were not quick enough to identify and understand it. I think the other thing that pushed a lot of private lending was just the low level of absolute rates and people’s need to meet their obligations. There’s a ton of businesses that are upscale. I think I saw the other day, 80%-plus of $100 million revenue firms are private. It’s actually terrific that the US capital markets are deep enough that they can all get funded outside the banking system. That has, I think, been what’s gone on the last 10, 15 years. I think we should all keep in mind that the banks back leverage a lot of those assets. The banks are still exposed. They’re just exposed at a lower attachment point and so actually in a much safer position than they would have been 15 or 20 years ago.
Will Private Equity Be Able to Gain Enough Retail Capital to Maintain Its Growth?
Lefkovitz: I’ve heard you talk in the past about how the expansion of private market investing and private equity funds have impacted public markets, especially in the small-cap space. Curious how you think about the impact of private capital on public markets generally?
Selmo: Yeah, I think that, like I said, a couple years ago, they were a very competitive buyer for interesting mid-cap companies. I think that they’re a little bit less so now. I think the other impact has been part of the sucking capital out of the, call it, mid-cap fund specialists in the long-short equity funds. I think that the performance of private equity has been strong enough that it’s really sucked up a lot of the capital that would have previously gone to those managers. Now, what I suppose is going to be interesting is that as you’ve had very low returns OF capital, not necessarily ON capital. We don’t know how that will play out yet, but in terms of paying back of LPs, LPs seem to be getting to a point, traditional LPs, seem to be getting to a point of being tapped out on private equity and maybe for institutional specific reasons, but there’s a couple of famous leaders in the space that are apparently shopping chunks of their private equity portfolio. If private equity isn’t able to tap retail capital in a meaningful way, we may be at a point where the growth in private equity starts to slow down a little bit, but we’ll have to see how it plays out.