The Paper Trail: Climbing a Wall of Worry

Welcome to the final edition of The Paper Trail for 2024! I'm posting a bit earlier than normal this month so I can shut it down for the remainder of the holiday season and enjoy some year-end R&R.

Thank you for your continued readership and support of this blog. From my family to yours, wishing you a happy, healthy, and prosperous 2025!

It's always fun to share my own research in The Paper Trail and I am happy to include my latest white paper for Cliffwater - "Direct Lending's Wall of Worry" -  in this month's installment. I address the steady drumbeat of negative headlines that the private debt asset class has received in recent years, contrasted with what we believe to be strong fundaments and prudent capital deployment in action. In short, any claims of a private debt bubble fail under scrutiny. 

In addition to my own piece, December's research roundup features:

• GP-led secondaries in VC/Growth
• Sizing bitcoin in a portfolio
• Avoiding dividend-paying stocks
• Sector specialists in private equity
• AI infrastructure and next-gen data centers
• Permanent crops and farmland investing
• U.S. equity market outlook
• The exit environment in private markets
• Portable alpha and managed futures
• Long volatility strategies
• Passive investing's impact on markets
• Non-U.S. small caps

Are the negative headlines about private debt in line with reality or is the financial press misguided?

"The headlines scream doom, but the numbers tell a different story. Direct lending continues to deliver what investors seek: steady returns, high income, resilience through cycles, and disciplined risk management. For investors who cut through the noise and focus on the data, private debt remains a compelling cornerstone of a diversified portfolio—far from the bubble narrative."

Direct Lending's Wall of Worry (Cliffwater)

How should venture capital and growth equity GPs navigate the secondaries market to provide liquidity to their existing LPs?

"To guide GP-led execution, it can be helpful to map transaction goals along two axes: complexity (X-axis) and impact on GP/LP economics (Y-axis). This framework helps identify solutions ranging from simple LP tenders to more complex consolidation funds."

Best Practices: Managing Liquidity through General Partner-Led Secondaries (Industry Ventures)

What is the optimal allocation, if any, to bitcoin in a diversified portfolio?

"The upshot? By allocating no more than 2% to bitcoin, investors would: 1) introduce a very different source of return and risk; and 2) manage risk exposure to bitcoin. We think investors who choose to allocate to bitcoin should regularly review bitcoin’s changing nature and their allocation. Bitcoin is becoming more accessible to institutional investors. Wider adoption and trading could reduce its volatility and make its low correlation with equities more stable. Lower volatility would trim bitcoin’s contribution to portfolio risk and allow investors to up their allocation. Yet broad adoption could also mean bitcoin loses the structural catalyst for further sizable price rises. The case for a permanent holding may then be less clear-cut and investors may prefer to use it tactically to hedge against specific risks, similar to gold."

Sizing Bitcoin in Portfolios (BlackRock)

Should investors avoid dividend-paying stocks?

"It turns out that the simple value strategy (which included avoiding high yield stocks) produced higher returns than the dividend strategy – not just similar returns. In other words, before we even get to the tax benefits, “value” had already trumped “dividends.” And after factoring in taxes? Even more outperformance."

Is the Best Dividend Strategy to Avoid Them? (Cambria Investments)

Do sector specialists have an advantage in private equity?

"In summary, sector specialists have a distinct advantage over generalist managers, utilizing their deep industry expertise and networks to source and win more deals as well as help companies improve operating performance. With their unique insights, gained from careers dedicated to a specific sector, sector specialists have been able to outperform generalists on both an absolute basis and relative to the public markets, firmly establishing their value and ensuring they will remain a driving force in the investment landscape for the foreseeable future."

Edging Out the Competition – The Sector Specialist Advantage (CF Private Equity)

Are we underestimating the demand for next-generation datacenters and the investment case for AI-related infrastructure?

"Ultimately, only informed investors who grasp the nuances of AI infrastructure will be able to capitalize fully on these emerging opportunities. The specialized nature of AI hardware, networking, and power systems requires a sophisticated understanding of the market to navigate successfully. Those equipped with the right knowledge and talent will be well- positioned for long-term growth as AI continues to evolve."

Investing in AI Infrastructure: Data Centers of the Future (Magnetar)

What are permanent crops and how do they fit into farmland portfolios?

"Permanent crops can be an important part of a farmland portfolio and complement investments in annual cropland by providing investors with higher current incomes, broader diversification, and greater exposure to foods consumed directly by humans. Despite recent low profitability, permanent crops have still generally produced positive income returns, albeit much lower than historically experienced. The long-lived nature of permanent crops tends to cause production to be slow to changes in economics in the short run. As a result, permanent crops can experience prolonged periods of weakness; however, it also means efficient operations with long-term capital can also realize prolonged periods of strength."

Enhancing Farmland Portfolios with Permanent Crops (US Agriculture)

Can U.S. equities make it a trifecta with another year of top-quartile returns in 2025?

"Overall, it would take dramatically higher earnings and valuations in 2025 to
achieve higher returns than 2024. We think that is unlikely because the market is already pricing in elevated levels."

2025 Outlook (Cambridge Associates)

Has the model for achieving "exits" in private markets permanently changed?

"The exit environment overall is governed by both cyclical and secular factors. Cyclical factors get a lot of airtime. Often mentioned are supportive macro, LP allocations right-sizing, and “animal spirits”. But the incentives facing sponsors get a vote. And sponsors today seeking to maximize their probability of survival face an environment that incentivizes retaining assets, lengthening their liabilities, and avoiding replacement/origination costs. This is the New Exit Game."

The New Exit Game (Arctos Partners)

Are managed futures the ideal complement to equities in a "portable alpha" strategy?

"By adding managed futures to portable alpha structures, investors do not just port over the alpha: they also inherit some of the powerful, almost antifragile properties of managed futures. This crucial feature can fortify the portfolio, making it more resilient whilst enabling it to withstand all the phases of a market cycle."

Portable Alpha: Finding the Right Match (Aspect Capital)

What role do long volatility strategies serve in a portfolio?

"Long volatility strategies serve as a crucial component in an investor’s toolkit, providing a robust defense against sudden market downturns. These strategies are designed to offer protection during the initial stages of market shocks, making them an essential part of a broader risk mitigation approach. By incorporating long volatility strategies, investors can better manage uncertainty and enhance the resilience of their portfolios."

Long Volatility Investment Strategies Primer (Meketa)

How has the rise of passive investing changed market structure?

"With strong upward momentum in large-cap stock prices, passive flows are therefore likely magnifying the upward pressure on demand for large and mega-cap stocks, and decreasing demand for small-cap stocks."

Assessing the Impact of Passive Investing over Time: Higher Volatility, Reduced Liquidity, and Increased Concentration (Apollo)

Are investors missing out on the potential of non-U.S. small caps?

"Over the long run, we would encourage allocators to view small-cap exposure as an uncompensated risk factor that is well worth taking to exploit stock-selection opportunities in a relatively inefficient segment of the market. Based on a forward-looking perspective, stay both invested and active in non-U.S. small caps."

Non-U.S. Small Caps: A Call to Inaction (Acadian Asset Management)