The Rewind: Lines in the Sand
The Memo by Howard Marks Podcast Recap
Published:
Summary
Howard Marks revisits his 2017 memo "Lines in the Sand," discussing the implications of financial strategies like subscription lines on investment metrics. He highlights the potential for these lines to inflate Internal Rate of Return (IRR) figures without enhancing actual wealth, emphasizing the...
What Happened
Howard Marks reflects on the contents of his memo 'Lines in the Sand,' first released on April 18, 2017, to provoke thought about the implications of financial strategies like subscription lines. He distinguishes between dollar returns and percentage returns, emphasizing that a higher Internal Rate of Return (IRR) doesn't inherently translate into greater wealth accumulation.
Marks examines the rise of financial innovation during economic booms, noting it is typically driven by profit motives. Subscription lines, used by fund organizers to draw money from banks instead of investors, can artificially inflate reported IRR without changing the actual multiple of invested capital. Although not considered leverage, these lines can cosmetically enhance IRR figures, potentially misleading investors about a fund's performance.
IRR is highlighted as an imperfect measure of performance, since it doesn't account for uncalled capital. Marks argues that a single metric like IRR, Multiple on Committed Capital (MOCC), or Multiple on Cost (MOC) isn't sufficient to evaluate a fund's success. Instead, a comprehensive view considering committed capital, invested capital, investment duration, and returns is necessary.
The use of subscription lines can also affect cash management, as it defers the calling of Limited Partner (LP) capital, giving an impression of fewer capital calls. This deferred calling can lead LPs to invest elsewhere, potentially resulting in leveraged positions if capital calls occur unexpectedly.
There are inherent risks associated with subscription lines, especially if LPs fail to meet capital commitments during a financial crisis. Marks notes that while strategic defaults are unlikely due to significant penalties and reputational damage, simultaneous LP defaults could force funds to liquidate assets under unfavorable market conditions.
To mitigate these risks, Oaktree has begun developing guidelines to preserve the benefits of subscription lines while minimizing potential downsides. Marks stresses the importance of preparing for tough times, ensuring that financial strategies are robust enough to withstand crises.
The widespread use of subscription lines is largely driven by the desire for high IRRs and improved cash management, but Marks cautions that a high IRR can be misleading, especially if it is achieved with minimal capital over a short period.
Howard Marks references his 2006 memoir 'You Can't Eat IRR' to underscore the importance of focusing on dollar profits rather than percentage returns. He uses this reference to bolster his argument against relying solely on IRR as a measure of investment success.
Key Insights
- Howard Marks distinguishes between dollar returns and percentage returns, cautioning that a higher Internal Rate of Return (IRR) does not necessarily equate to increased wealth. He emphasizes the need to focus on actual dollar profits over percentage figures.
- Subscription lines are bank loans that allow fund organizers to draw money from banks instead of investors, affecting reported IRR. They are not considered leverage but can cosmetically enhance IRR figures without increasing the actual multiple of capital.
- IRR is deemed an imperfect measure of fund performance, as it fails to account for uncalled capital. Marks suggests that no single metric is sufficient to assess fund success, advocating for a broader view that considers various financial metrics.
- The use of subscription lines poses risks, particularly in financial crises. If Limited Partners (LPs) fail to meet capital commitments, funds may be forced to liquidate assets during downturns, potentially resulting in significant losses.