Weekend Reading: McVey’s “Misalignment Triangle”

In a very insightful analysis, Morgan Stanley’s Chief Investment Strategist, Henry McVey, has connected the dots between private equity’s low hurdle rates versus corporate America’s high hurdle rates and the big long-only mutual fund managers’ need for performance.

Henry sees “a perverse set of incentives…afflicting the capital markets”. He goes on as follows:

“...(the) lack of corporate oversight at the company level as well as portfolio managers’ mandates to beat their benchmarks, not necessarily maximize value, is allowing private equity firms to ‘steal’ trophy properties at less than fair value.”

“…CFOs still believe that the risk premium associated with their businesses is around 9.0%.” “…our work shows that the equity risk premium on the S&P 500 is currently around 3.75%.”

“The problem, or the disconnect, lies in the misalignment of incentives throughout the system, and in three areas in particular. Whereas private equity firms are paid to use leverage to recoup cash flow as soon as possible, corporate executives are ‘safest’ in a post-Sarbanes-Oxley environment if they run their businesses with high cash balances and lower-than-average risk profiles. The final piece of the Misalignment Triangle centers on the big long-only, buy-side shops, many of whom are willing to sell shares at less than fair value because the ‘pop’ from the deal announcement is more than enough to help them beat their near-term benchmarks.”

Investment Strategy Implications

While many investors tend to get tangled up in their underwear over cyclical issues, I try to identify the more significant thematic issues that cross boundaries and have larger secular impacts on the markets. McVey’s “Misalignment Triangle” joins Rich Bernstein’s correlation analysis as thematic perspectives well worth your time exploring and understanding.

Have a good weekend.

Quotes are from Morgan Stanley Strategy and Economics, “Revisiting the Misalignment Triangle”, March 16, 2007.