How will Covid-19/Coronavirus Affect my Alternative Investment Portfolio? (Part 3: My Strategy)
Updated: 13 hours ago
Having examining the possible virus scenarios and effects on the economy, we now dive into what they might mean for alternative investments. Plus, my personal investment strategy.
(Usual disclaimer: I'm just an investor expressing my personal opinion and not a registered financial advisor, attorney or accountant. Consult your own financial professionals before making any financial decisions. (Code of Ethics: I/we do not accept any money from any sponsor or platform for anything, including postings, reviews, referring investors, affiliate leads or advertising. Nor do we negotiate special terms for ourselves in the club above what we negotiate for the benefit of members.).
In part 1 of the series, we talked about the coronavirus that causes Covid-19 and what we do and don't know about it. In part 2, we talked about 4 possible scenarios and what they might mean for different sectors of the economy.
Now in this, part 3, we'll talk about what this may mean to different alternative investment asset classes (real estate, litigation finance, life settlements, music royalties and medical royalties). And then we'll talk about my own personal investment strategy going forward.
Real Estate Gloaters
After the public market meltdown, many real estate sponsors sent out updates to investors on their Covid mitigation strategies. But there were a few who took a different tactic and instead sent out gloating emails. Their argument was that other markets crashed, while their own investment opportunity didn't, and so people should be sending investment dollars their way.
It's true that real estate pricing is not directly tied to the business cycle and there has been no crash at all in private real estate. However. this also doesn't mean that real estate is guaranteed to be crash proof in the future.
The gloaters may end up being right (and we'll talk about a few scenarios where they might be). But in my my opinion, it's too early for any asset class to do any legitimate trash talking yet.
A Tale of 4 Viruses (part 2)
In part 2, we discussed what I believe are the 5 most likely scenarios for how long the virus will take to run its course. The longer that takes, the worse the economic damage and, potentially, the more disruptive it will be to a portfolio. Here are my thoughts on how those scenarios could play out:
1) "Saved by the bell": Very short: 0 to 1 month -- and -- 2) "Shorter:" 1 to 2 Months
In the past, previous virus-caused disruptions have been brief, and followed a typical pattern. At the beginning, there's a fast downturn and then an equally rapid recovery and an "over-surge" a quarter or two later:
So, if either of these shorter scenarios happen, certain commercial real estate sectors with heavy exposure to control-measures would come under low to significant stress from the disruption. These would include hotels, customer facing retail, restaurants, gyms, non-critical medical etc. as described in part 2. But, as long as companies don't start issuing significant layoffs, other types of commercial real estate like multifamily and office would be expected to rebound relatively quickly. And grocery stores and pharmacies could expect to do even better than normal.
New construction and home-buying would also be delayed and affected. This would affect not only the timing of some equity deals but also potentially the paybacks of hard money loans on funds that specialize in residential rehab or construction. Again without significant layoffs, these could be expected to rebound relatively quickly.
Some of the more heavily leveraged offerings and/or the more speculative strategies could be expected to run into trouble. But, more conservatively underwritten, less aggressive strategies should not experience much net disruption.
Other strategies like litigation finance, life settlements and drug royalties would also be unlikely to experience much disruption.
Music royalty investments would expect a drop in live performances but arguably a much higher increase in streaming, video and movies (with many more people spending time at home and looking for entertainment to pass the time). So this might lead to a profit boost. (or at the very least might provide solid protection from loss of principal versus other asset classes that are more correlated).
If either of these scenarios happen, there might be an opportunity for some discount buying of distressed assets. And this also would mean that there's now a once-in-a-decade opportunity to pick up public market stocks at a 20%+ discount.
3) "Longer": 2 to 6 months
As mentioned in part 2, many companies are highly indebted and can't take operating at a loss for very long. If they have to sustain longer-term stress like this, there almost certainly will be significant layoffs.
If this happens, then national GDP would probably go negative. And on the longer end of this time span, there would be a significant risk of a technical recession (2 or more quarters of negative GDP). Also, the longer it takes, the more potential for secondary factors to kick in and cause a less-strong rebound and "over-bounce" (versus the previous scenarios).
Control-measure sensitive commercial real estate would come under immense stress. Presumably many would experience huge drops in occupancy and rent which would cause them to have to either raise additional money from investors or default on the debt (and go under). If that happens, then deals with sponsors with low skin in the game and/or shallow pockets could be most at risk.
Office and multifamily should presumably be in better position but would still not be immune. In past recessions, both have experienced drops in occupancy and rent. And office has been less recession-resistant than multifamily (because people will downsize an office before they downsize where they live).
I would expect many of the more aggressively underwritten deals (higher risk strategies, higher use of debt) to come under significant stress and again require cash injections from investors and/or go under. Conservatively underwritten deals should be in much better position. But even here, no deal can take infinite stress. If the virus ran a very long time, even these deals could start feeling the heat. Again, deals with sponsors with deep pockets and significant skin in the game could probably expect better outcomes than those without.
An X factor here is commercial real estate pricing. Contrary to proper belief, prices are not directly tied to the US business cycle, and instead depend on global factors like the inflow of capital and the desirability of real estate versus other asset classes. So if prices stay steady or rise (like they have in 50% of recessions) this would help mitigate some of the damage.
On the other hand, if they fall, then that could cause additional problems. For example, deals structured with short-term debt that came due during this period, would have difficulty fully refinancing at the lower price. So those investors would also have to pony up more cash or see the deals blow up.
Which of the two ways that pricing would end up going, would be anyone's guess.
One additional X-factor here here is that the unusual nature of the downturn could cause certain asset classes to act differently than they did in past downturns. For example, in the last recession, Class A apartments (the most expensive) did much worse than mobile home parks (the least). Mobile home parks are at the bottom of the housing heap. So even though they lost tenants, they also gained them from people higher up who are downsizing. But Class A is at the top of the heap and didn't gain any.
However, in a long-term virus lockdown situation, many Class-A dwellers might arguably be digital workers who can work from home and still stay employed. And very few mobile home parks' blue-collar jobs can go virtual, and these people might be much more likely to lose jobs. Factors like this could cause surprises.
Again, there almost certainly will be an opportunity for those who have set aside cash to pick up deals from others who were careless and/or too aggressive beforehand. People will probably be able to purchase assets at once-in-a-generation discounts.
Litigation finance is uncorrelated to the business cycle but still requires a functioning court system. So control measures could delay the hearings of cases which might reduce returns. But these seem unlikely to be so severe that it would cause principal loss.
Drug royalties might also experience delays since lab work can't be done by employees remotely and government approval agencies might be overloaded. But again it seems unlikely to be so severe that it would cause loss of principal.
As mentioned in part 2, one of the potential scenarios here involves hospital overload. If that happened, it would be tragic in terms of human life. At the same time, purely from an economic point of view, it would be positive for investments in life settlements.
Presumably, music royalties would also still experience the positive tailwinds as the previous scenario to also protect it from loss of principal.
Finally, in this scenario I think there would be a lot of pressure for government assistance to help people who have lost jobs or are otherwise negatively effected (as mentioned in part 2). If legislation were passed, it might mitigate some of the negative short-term economic effects (although also potentially have some negative longer-term effects).
4) "Very long": 6 to 12 months.
This scenario might involve much lower human suffering from the virus, but very high levels of suffering from the economic effects of job loss and unemployment.
As we talked about in part 2, I think this scenario would almost certainly also involve significant government assistance to those affected. So this would mitigate some of the economic damage. But I think, overall, it still would be an economically crippling scenario.
In this situation, I think no aspect of real estate would be spared and would be looking as bad as public markets do right now.
Fortunately, this scenario might not involve a hospital overload. If so, then that might also mean that life settlements would not get a boost from that.
Litigation finance and drug royalties seem like they would experience additional delays and problems, but again not to the level of losses of principal. And music royalties would also presumably experience positive tailwinds to also protect against loss of principal..
"Alright. So *which one* do you think will happen"?
At this point, it's too early to tell exactly what will happen and it's anyone's guess. So I may be completely wrong on anything here. And the below is what I think right now. But it could change tomorrow or next week or next month based on new information. I'll try to update this article with new information but can't guarantee that I will.
Please do not blindly follow me, but instead come up with your own independent opinion. And don't make any investment decision before consulting with your registered financial planner, attorney and accountant.
Sadly, I believe it's too late for the #1 "Saved by the bell" (very short: 0 to 1 month) scenario.
I also believe that the #4 "Very long" (6 to 12 months) scenario is possible, but at this point there's no evidence yet showing that the virus will require multiple waves of control measures. Nor am I seeing evidence that the U.S. has gotten very serious about imposing quarantines, restrictions and social distancing (i.e., things which would minimize the loss of human life, at the expense of the economy). This could change in the future. But until I see these kind of developments, I feel this scenario is less likely.
That leaves two scenarios: "#2 Shorter (1 to 2 Months)" and "#3 Longer (2 to 6 months)"
I personally feel that the testing snafus have caused the U.S. to drastically under-test and currently give us a false sense of the extent of the epidemic right now. Right now I feel the minimum time is 3 to 4 months (in a reasonably plausible scenario). If that happens, there will be significant job losses and negative GDP growth. I think there will be at least one negative quarter, and more likely two, which would make it a technical recession (two negative quarters of growth).
Unfortunately, I think the chance of hospital overload and large scale human suffering and death is high. If that happens, I would first expect to see school gymnasiums and sports arenas converted into makeshift hospitals.
In the medical journal, The Lancet, Italian doctors said their current hospital system will hit maximum capacity around Friday, March 21.
And in terms of reported cases, the U.S. is about 9 days behind Italy.
We're not the same as Italy in that we have much larger country, a different population, a different capacity healthcare system, etc.. So this is a very rough estimate. But perhaps we might hit our own maximum capacity around the end of March or early weeks of April.
I'd like to be wrong
I would like to be wrong and feel there's a reasonable chance I could be. If the warm weather and humidity will at least slow down the virus, and/or one or more of the retrofitted drugs pan out, it would help a lot. This would make the pain a lot shorter. There would be no hospital overload and we'd be in situation #2.
But since I'm a conservative investor, I'm going to plan for the worst (#3) and then hope for the best (#2).And if this causes me to end up with a lower return or miss out on some opportunities then I can live with that.
So what's your strategy?
I've already been concerned about a severe recession happening for a couple of years. So on equity deals, I've only been investing in sponsors with high skin in the game, deep pockets and a track record of having navigated past recessions with little or no money lost. I've also been requiring low leverage and conservative strategies. So I feel I've made the best decisions I could've made at the time to give myself the best shot of weathering what's to come.
I also have a large amount of cash available, which I'm going to continue to hold. If the scenario stretches out the long end, it's possible I may be asked to put in more money to a avoid default. So I feel comfortable there, and will be making sure that I stay in a financial position to be able to do that, if necessary.
In the last couple of years, I've also invested in hard money loan funds with zero debt and low LTV's. And I ran Great Recession stress tests, and only invested when I felt they would most likely only lose a minimal amount of principal. My intention was ideally to pull out if I saw signs of end of cycle deterioration (i.e., less conservative underwriting or increased defaults). Or in a worse-case scenario I felt comfortable holding them through the next recession.
However, there were some complications. One of them (Broadmark, which is a construction hard money loan fund) went public. Since this was an unplanned part of my public market portfolio, I sold 50% of it before the IPO to hedge against public market risk. So right now I'm feeling good about that decision.
Then, when coronavirus looked like a serious problem (but before the huge meltdown occurred), I sold another one third (at a profit over the initial IPO). So again I felt pretty good about that. In a perfect world, I would've also sold the rest of it and gotten cash to take advantage of distressed opportunities (discussed next). But at the time, there was not as much information, and I didn't think it would necessarily play out the way I do now.
So my default strategy will be to hold through the downturn (which was my original plan a few years ago). I'm not completely happy with this plan: I feel BroadMark was showing some cracks in underwriting before the IPO (although my due diligence on this was interrupted by the IPO). And construction loans have more risk than other types of hard money loan funds like rehab requisition. So I'm going to keep an eye on this. I definitely did not stress test a coronavirus recession on them. And if I start to believe we're moving more into the scenario of 6+ months or more, I would be uncomfortable with the possibility that a large number of defaults and how long it might take to recover. In that case I might just cut my losses and redeploy it into something much more productive (such as distressed opportunities mentioned next).
The other hard money loan fund I invested in is a rehab/acquisition fund called Arixa. I recently felt some of the data was showing cracks in the underwriting (although I need to add here that the sponsor has not yet had full time to respond to my analysis and they might prove that I'm wrong). So I recently exited one third of my holdings. Once I hear back from the sponsor, I'll decide if I feel comfortable holding the rest through the downturn or not.
In the last year and a half, I've also been putting my money into alternative investments that are uncorrelated with a business recession. By chance, many of them look like they'll also be coronavirus resistant, even though there was no way to know in advance. So I'm very happy with my litigation finance investments. And arguably, some might even benefit from the current situation: life settlements and music royalties. So I'm very happy about the decisions I made there, feel they give my portfolio the best chance of diversifying against bad news.
Part of my plan for holding so much cash was to be able to potentially take advantage of distressed buying opportunities from other investors who got overly aggressive. If either of scenario #2 or #3 play out, then there probably will be plenty of opportunities for me to do this. If so, then similar to the aftermath of the great recession, I think there will be very profitable once-in-a-decade or once-in-a-generation opportunities available. So patience and careful observation continues to be my strategy here.
So that's my current plan. But as events change, any and all of the above could change.
Regardless of what happens: I hope you and your family stay safe.