The historical opportunity for principled investors to take the leadership and the blueprint to reform the world
How to regenerate a Wave of New Prosperity: The fundamentals
Notwithstanding the rebound of the world markets, the current structural global crisis is far from being over. Furthermore, it seems that new distortions and “asset bubbles” are being recreated. Commodities and oil prices are dangerously inflated. While governments and public institutions continue in their struggle to support the financial system and to avoid an economic catastrophe, there is a huge gap and an opportunity for investors with integrity and high ethical standards to take the lead. These are Pension Funds, Endowments and Foundations, Sovereign Wealth Funds, Supranationals, Central Banks, cash rich councils, and institutional investors.
Two fundamental factors emerge clear and assume critical relevance.
The first one is the “cash constipation” of such institutional investors with free capital. Their problem is how to protect their declining assets and to identify new sources of yield and diversification to preserve their goals. Their risk is failing in their fundamental scope.
The second is the “capital starvation” of the real economy. i.e. the persistence of a deteriorating environment for “sound” enterprises and infrastructure projects, because of declining demand, fall in the level of confidence and trust, withdrawal of the banks’ support, etc… These companies and infrastructure projects now need resources, a strategic support to embrace new business models, to produce new sustainable offerings, and to insure long-term operations. Their risk of failure would further delay any form of possible recovery and deepen the current economic depression.
The legacy intermediaries, that traditionally favored the exchange and flow between those who had free capital and those who needed it, are frozen, technically in default and not in condition of providing such vital function. Furthermore, their business model is in tatters.
Hence, the strong players with long-term views and objectives find themselves not only in a highly superior and privileged position for the extreme widespread scarcity of capital and absence of willingness to invest it. These institutions face now a heavy responsibility and an opportunity: to take on the task of “financing” directly those meritable enterprises and projects with sound credit worthiness in their endeavors to respond to the challenges of a more balanced and sustainable development.
“Direct Investing”: a New Asset Class
I am proposing what is effectively a new investment category, which does not exploit the owner in terms of fees, governance, control and transparency.
This new asset class is necessary and made possible because of the dire unprecedented circumstances, and it is facilitated by technological and informational advancement.
“Operation Direct Growth”, is a strategic plan that focuses on the “direct reallocation of capital use” between long-term investment institutions with surpluses and real economy firms in sound conditions and prospects that yet need further resources and support.
There will be no intermediaries in the exchange. The main actors of this scheme will be a consortium of institutional investors, among Pension Funds, Central Banks, Endowments, Sovereign Wealth Funds, and Supranationals. The savings and efficiencies of this new “Direct Investments” will be considerable. This will regenerate a new wave of real economic growth and at the same time produce better guarantees of returns for the investors. It will ignite a virtuous circle, a return to hire people, reestablishing a circuit of confidence and trust, and the opportunity to stimulate a sustainable balanced and ethical growth.
The “direct exchange of capital” between the cash rich entities and the enterprises in need of capital is furthermore unavoidable. In fact, not only the enterprises recipients of capital flows would otherwise fail without it, but the entities contributors of capital would likely end up unwinding without a renewed source of yield for their investments.
The “savings” and efficiencies in implementing “Operation Direct Growth” are considerable. Factors enhancing the value of these investments and expected returns are:
1. No intermediaries = no implicit and explicit fees and inefficiencies
2. Enhanced Firm Value because of the “Direct Alpha Factor” (see later)
3. Foreign capital attraction = further value enhancement of the invested firms
4. New efficient way for Portfolio Diversification / Asset Allocation strategy
5. Governments incentives to the purchase of the invested company’s products
6. Tax breaks to be offered to these investment schemes
“Direct Investing”: Enhancements to develop Sustainable Growth
1. The first enhancing factor is represented by the savings of all layers of fees, commissions, transaction costs, implicit and explicit, charged currently by the financial intermediaries. In addition, there will be advantages in transparency, control, corporate governance and information flow.
2. 3. The second / third advantage will be an immediate enhancement of value of the invested firm because of the organized presence of one or more strong long-term investors (national and international) among the shareholders.
In previous papers, we presented the case of the extra value generated by the organized presence of a “Strong and Stable Investor”, by a large, stable, and non-speculative sponsor (“a strong hand”), as a shareholder/partner of a company or a specific project.
‘Direct Alpha’ was defined as the part of the company’s extra value generated simply by the organization or presence of such a “Stable Investor” among the shareholders.
The value of ‘Direct Alpha’ or αs, can be calculated using the CAPM as follows:
řt = expected return of a “Direct-Invested” enterprise
rf = Risk free rate
βt = Beta of the firm (or its security)
řm = Expected return of a similar firm with no “Stable Investor” among shareholders
Other things being equal, a purchase of a stake from a “Stable Investor” reduces the enterprise risk, enhances the probability of returns, gives stability and long term prospects to the business, attracts further investments, guarantees higher compliance and best business practices, and the value of this equation becomes positive. The company is therefore earning excess returns by virtue of the “Direct Investment Formula”. This is particularly valid in strong periods or recession and depression like the current one.
These were our findings within the framework of modern portfolio theory.
Yet, we took our focus a step further and analyzed the same phenomenon viewed more properly in terms of a stronger downside protection. Estimating the value of a “Strong and Stable” shareholder’s presence, in terms of downside risk analysis, showing a lower probability of an underperformance rather than of a higher value of returns.
In particular, in a Downside Risk scenario the method of ‘Average Shortfall’ seemed the most appropriate to explain in a behavioral and circumstantial way the evaluation and choice of “direct investments” and to determine an optimal asset allocation.
Average Shortfall is defined as the average size of a strategy’s underperformance relative to the target rate of return. The general definition of Average Shortfall can be expressed in terms of the underlying probability of returns, f(r), as:
Here, τis the target return, and r denotes the random value of the return, both expressed as rates over a given time interval.
Average Shortfall measures the average amount per period that a strategy underperforms the target. It is measured in units of return, and so is more closely linked to financial decision making than just Shortfall Risk, which instead measures downside risk as the probability of underperforming the target. Average Shortfall is a risk measure that explicitly incorporates a performance target and the time horizon, and provides an intuitive measure of the cost of underperformance. It is relevant to notice that Average Shortfall analysis covers also event risk cases and can be used to evaluate the performance of assets which generate (or may generate) returns that are not normally distributed. It is therefore able to consider the return patterns of all asset classes and in all real circumstances. It is a behavioral, as opposed to statistical, risk concept, that calculates explicitly a strategy’s potential for monetary loss. In fact, it can be shown to be equal to the “fair value” of insuring the strategy against losses.
Average Shortfall can also be viewed as a measure of the insurance cost an investment or a portfolio would need in the long term in order to keep the performance within the target.
Therefore, by reducing downside risk and giving a more stable and long-term prospect to the business, the organized presence of a “Stable / Permanent Shareholder” has the impact of minimizing average shortfall and can provide the value of such an insurance in exchange for a “Privileged Shareholder” position.
Thus, “Direct Investing” appears to be a viable way to create real value and unblock the current situation in which the global economy is frozen. Investors are inclined to give up some of the upside potential in return for more stable returns or, a guarantee of a better downside protection: a capital loss weighs more than a gain. The presence of a strong and not speculative investor among the shareholders reinforces this objective. In exchange for a privileged preference shares remuneration position, the strong shareholder acts as an insurance to balance and redistribute risk in favor of more stable and solid returns.
Thus, if investors care differently about downside losses versus upside gains, they therefore prefer to invest into stocks with low sensitivities to downside market movements. Now it is evident that in today’s’ environment investors are frozen, banks even worse so, and that capital and liquidity stopped flowing.
4. The fourth advantage will lay in the real diversification that this new direct asset allocation provides. In fact, “Operation Direct Growth” will consist of a “participation” in a portfolio of companies and infrastructures taking the form of “preferred investments”, presenting some characteristics and qualities of both equity and bonds. These investments will generate pre-agreed returns and carry guarantees in case of a deterioration of credit worthiness, entailing a privileged credit status.
5. The fifth factor of advantage will be the boost in demand for the offerings produced by the invested firms in receiving government incentives. These will be directed towards renewable energy, sustainable growth, rationalization of products and processes offerings. While on a different level to public efforts to save ailing sectors, “Operation Direct Growth”, will actively seek to attract various governments’ incentive programs to favor demand for the products of the supported industries.
6. The sixth advantage factor will lie in negotiating and receiving tax benefits for the committed investments returns. In fact, the Plan aims to receive fiscal benefits that will be higher the longer these investment commitments are kept.
“Direct Investing”: New Form of Diversification and Asset Allocation
Such a new investment way is directed towards real economy infrastructures and sound enterprises that due to the current unprecedented and prolonged negative circumstances, need capital to capture business opportunities, or which prospects risk deteriorating for the continuation of the general lack of trust and/or for absence or withdrawal of banking facilities. Therefore, the investment subjects will be in “sound” sectors with good growth potential, such as: new technologies, renewable energy, sustainable growth, IT, biotechnology, education, creative industry, economic rationalization and restructuring of products and processes, infrastructures and in those sectors that will receive government incentives. The aim is not to rescue faltering companies but to favor merit able enterprises. Such interventions will observe ethical values and full respect of best corporate governance practices.
“Operation Direct Growth” will be composed of the following main functions:
- Identification of investment targets and infrastructure projects universe
- Credit worthiness evaluation process and screening criteria
- Portfolio selection, diversification and asset allocation strategies
- Contractual negotiation and structuring with enterprises and governments
- Monitoring, rebalancing and updating process
- Communication exchanges and co-investments with similar Direct Investors
“Enlightened” communication and cooperation in scope and space
I focus here on the last factor which affects the others mentioned. This is the opportunity for the development of a more active and “enlightened” role of communication and cooperation in scope and space between principled investors with similar term horizons and scopes, and all major market players. The development of a new dynamic network of relationships will be an important key to help perform the main function and objective of Direct Investors. The latter can be enhanced through a real global exchange to be achieved with a pool of major market participants. Global consensus on international cooperation it is an opportunity and it must now be productively used.
Not just more information but of superior quality will be instrumental in risk diversification and attracting foreign free co-investment capital. This undoubtedly requires the active coverage of a comprehensive pool of market participants among which the very important category of the Sovereign Wealth Funds. Effective relationship, participation, thus achieving true global market intelligence and knowledge.
The development of an “observatory point”, a center of information integration and of active exchange between all “Direct Investors”, like-minded and principled institutions and market players and forces is today impossible to ignore. Functions to be performed:
- Start research on these institutions
- Develop a program of regular communications
- Where proper share asset allocation strategies, co-investment opportunities or cooperation in the case of a foreign institution in investing in a national firm.
Direct Investing: A New Avenue of Finance to the Real Economy. Conclusions
Principled long–term institutional investors with ethical values such as Pension Funds, Endowments and Foundations, Central Banks, Sovereign Wealth Funds, Supranationals, and several large institutional investors, must now take the lead and embrace a historical opportunity. To invest directly into the real economy and begin a necessary transformation development.
Having a long term investment horizon, providing directly liquidity and capital to meritable enterprises, “Direct Investing” will relieve market operations, restarting the flow of capital and lowering its cost, thus supporting a reversal of the current depression.
Generating wealth as “Direct Alpha”, this pool of free capital could be a crucial element in a much needed national and international economic reconstruction. This will generate a necessary boost, it will enable companies to regain trust and go back to work, to de-lever, to free up capital for rehiring employees, for capital expenditures and future development plans. The “Direct Investments Formula” appears to be the tool to reform the world and steering it toward longer term goals, ethical values and balanced development. Early entrants will also enjoy the benefits of being able to secure the best investment cases, to acquire a leading hedge in industry expertise and learning curve.
Direct Investors will also have the advantage of attracting other stable investors, so multiplying the impact and magnitude of this process. This will also contribute to achieve the goal of a much needed global financial Stability.
Entrepreneurs are simply those who understand that there is little difference between obstacle and opportunity and are able to turn both to their advantage. Niccoló Machiavelli