On Skill, Luck, and Cheap Money

If you’re like me and you entered the investing world well after 2008, for most of our adult lives money was cheap. I’ve been thinking a lot lately about how difficult it is to separate investing skills from the environment in which that skill was developed.

For long stretches of the period following the financial crisis, interest rates sat at or near zero. What happened? Capital became extraordinarily abundant, debt was inexpensive, and as a result, investors searching for yield moved further and further out on the risk curve. This caused asset prices to balloon, capitalization rates to compress, and valuation multiples to expand. Ever increasingly large pools of money competed for ever increasingly expensive assets.

This means that an entire generation of investors built their careers inside this environment. I’m part of that generation too, and I sometimes wonder how much it distorted our understanding of what good investing actually looks like.

I want to be clear: this is not an argument that the people who generated extraordinary returns over the last fifteen or twenty years were not talented. Many of them clearly were. Some built incredible businesses, identified enormous secular trends, bought assets intelligently, improved operations, allocated capital well, and took risks other people were unwilling to take. But, the reality is that they were also investing with an extraordinary wind at their backs.

Of all asset classes, real estate may be the easiest place to see it. Imagine buying a building using significant amounts of debt. Your cost of borrowing capital plunges, rents rise, and cap rates compress. The real estate asset becomes more valuable, partly because the income has increased, but partly because the market is now willing to pay a higher multiple for the same dollar of income. Somewhere along the way, you refinanced, pulled some of your equity out, and eventually sold the building for considerably more than you paid. You may have been a very good real estate investor, but interest rates were working for you almost every step of the way.

Private equity experienced its own version of this. Firms could borrow enormous amounts of money relatively cheaply, acquire businesses, improve them, and benefit not only from earnings growth, but from expanding valuation multiples. If you bought a company at eight times EBITDA and eventually sold it at twelve times, some portion of your return came from whatever you did to the company in between, but some portion also came from the world deciding that twelve was the new eight.

If you buy an asset with cheap debt, grow earnings modestly, and then exit into a market willing to pay a higher multiple, the equity return can look spectacular. The IRR may tell a story of extraordinary investment judgment even if the underlying business itself improved only modestly. The use of leverage is not somehow illegitimate. An astute investor will tell you that using leverage intelligently is part of investing. But, the reality is leverage can blur the source of the return. Was the investor right about the asset? Was the investor right about the financing? Did the business actually improve? Did the market simply reprice the asset upward? Did falling rates make the exit easier? Did time and cheap capital rescue an underwriting mistake that would have looked very different in another environment? Most successful investments contain some combination of all of these. The difficulty is that the final return number compresses them into one result. We look at the outcome and call it skill, and sometimes it is. However, sometimes the capital structure and market conditions did more work than the investor did.

I find that increasingly interesting because investing has a strange feedback mechanism. If you generate strong returns, you raise more money. If you raise more money, you do larger deals. If those larger deals perform, your reputation grows. Eventually, the original investment results become evidence that you possess some durable ability to understand markets better than other people. Sometimes, that is indeed true. But, what if part of what you understood better than everyone else was simply a market regime that persisted just long enough for people to mistake it for a law of nature? The longer a favorable environment lasts, the harder it becomes to see the environment itself. This means that low rates stop feeling like low rates. They simply become the rate. High multiples stop feeling like high multiples. They just… become the way assets are valued. Cheap leverage stops looking like an extraordinary privilege, and becomes an ordinary part of the capital structure. Everything starts to feel normalized, and eventually an entire ecosystem forms around assumptions nobody remembers making.

There is also a survivorship problem here that I think is easy to miss.

Often, when we study great investors, we tend to study the people who won, but the winners we study were themselves selected by the environment they operated in. If cheap money disproportionately rewarded leverage, scale, duration, and financial engineering, then the people who rose to the top during that period were, at least in part, the people whose strategies were best suited to that particular world. We may not just be learning from successful investors. We may be learning from investors who were successful because a particular regime selected for their style. That doesn’t make their skill less real, of course. It does make me wonder how portable that skill is. We like to believe that if someone is great, they are simply great. But finance is full of people whose strengths were shaped by the exact conditions they happened to encounter. The harder test is whether those strengths can evolve when the environment changes.

Someone can be genuinely excellent yet still be optimized for a world that simply longer exists. A private equity investor can be exceptional at buying businesses, recruiting management teams, and driving growth, while also benefiting from a market that consistently offered cheap leverage and generous exit multiples.

I think that’s what makes the post-2022 environment so interesting (and unsettling).When the cost of capital changes, you begin removing at least some of the assistance the previous environment provided. A mediocre business cannot necessarily be rescued by financial engineering or an increasingly generous exit market like it used to. There is no life raft.

I do suspect we are going to learn a lot about investors over the next decade.

This isn’t because higher rates automatically make someone a better or worse investor, and not because every investment made during the low-rate era was somehow easy. Investing is never easy. But, different environments reveal different things. When asset prices are generally rising, it can be difficult to distinguish someone who understood an asset from someone who understood the direction the market was moving. Moreover, when leverage is cheap, it can be difficult to distinguish brilliant capital allocation from a capital structure that was just unusually forgiving.

When almost every reasonable asset appreciates, being right and making money can start to feel like the same thing. They are not always the same thing.

The other thing that changes in a higher-rate world is the hurdle itself.

For years, when cash yielded almost nothing, investors were pushed toward risk because doing nothing paid almost nothing. That means a strategy generating a 10% return could look extremely attractive when the alternative was close to zero. That comparison looks a lot different when cash or short-duration government debt yields something meaningful (or in other words, more than nothing). Returns are no longer being judged against the same baseline.

I find that important because we often talk about returns in isolation, as though 10% is always 10%. It is not. The value of a return depends partly on what else was available at the time, how much risk was taken to earn it, and what the cost of capital looked like at the time. You come to realize that a lot of investing brilliance is really relative brilliance. Leverage complicates this even further because it can make mediocre underwriting look much better than it actually was.

This has made me think differently about track records. A ten-year track record sounds like a very long time. In human terms, it is. Entire careers can be built in ten years. In market terms, however, I’m not sure it’s always long enough.

If those ten years happened to occur entirely inside one monetary regime, one credit cycle, or one overwhelmingly dominant market narrative, perhaps what you have observed is not ten independent years of evidence. Instead, what you’ve observed is just one environment ten times.

There is also something uncomfortable about writing this because it applies just as much to my own thinking. Almost everything I know about investing was learned during an unusual period in financial history. The models I built, the valuations I became accustomed to seeing, the venture rounds I watched get financed, the transactions I worked on, the investors I learned from, and even my basic intuition about what capital should cost were all shaped by the environment around me. The worrying part is some assumptions become so embedded in you that you do not even realize what they are: assumptions.

You think you are learning how the world works, but sometimes you are learning how the world worked during the particular twenty years when you happened to be paying attention.

That realization is humbling. We spend an enormous amount of time studying investors and relatively little time studying the conditions that made their investing possible. We attribute outcomes to individuals because people make better stories than interest-rate regimes do.

Maybe the fairest way to think about the last few decades is that skill and luck were intertwined, as they probably always are. Great investors took advantage of an unusually favorable environment better than other people did. Make no mistake: that itself required judgment, courage, discipline, and skill. The mistake would be assuming that all of the return belonged to them; we know that the market environment gave something too.

Now that the market is giving something different, I’m curious to see who was actually good at investing and who became extraordinarily good at investing in the world we just left behind.