YWR: The Private Equity Winter.
Disclosure: Personal views only. Not investment recommendations.
Maybe you know this already, but I have the supernatural ability to periodically detect when common sense ideas or predictions are going to be spectacularly wrong. I came across two of these this week. They seemed unrelated at the time, but actually there is a connection. I’ll explain later.
Crypto Winters
I am blessed with this supernatural power, but it also tortures me. A small throwaway comment within a seemingly innocent conversation will bother me for days. For example, this week I was speaking to a crypto researcher who had just returned from an investment conference in Palm Springs. I asked him about the conference, his main takeaways and the mood in the conference given the sell-off in crypto prices. He said one of his main takeaways was that despite the sell-off everyone at the conference was in a good mood. In fact they thought maybe the sell-off would be a good thing. Kind of like the pause that refreshes. The crypto community had been through winter seasons before, and were highly confident in the development of the underlying blockchain technology, so a periodic sell-off was an opportunity, not something to stress about.
At the time I nodded and agreed. It all made sense and mirrored my own view too, but over the next two days that conversation bothered me. I didn’t like the complacency. “There’s going to be a sell-off, but it will be relatively short and followed by new all time highs, so its all good. In fact we will just ignore the price fluctuations and use the downturn to build out even better products for the blockchain. Winters are a good thing.” I worry the market gods don’t like complacency, and it made me wonder if the surprise for investors and these conference participants will be that spring takes longer to come than they are accustomed to. Maybe the next downturn will not be a two year sell-off like in 2000-2002 and 2007-2009, or 6 months in 2020, but a drawn out a 3- 4 year bear market which maybe goes sideways for a while and then takes another leg down. You think it is over and then it has one more storm. So if you are in the space, just be conservative and prudent with your cash.
The scenario for this would be where for specific reasons, some of which we can see already, inflation stays high longer than expected and despite a market sell-off the Fed is stuck in a tightening mode. It’s interesting that some governments are already talking about stimulus checks for consumers to help with the pain of high energy prices. A repeat of the Covid stimulus, but for energy. This is interesting because it is the opposite of the deflationary dynamic we had post the GFC where central banks were trying to stimulate the economy with low rates and QE, while at the same time government fiscal austerity was reducing the effectiveness of their monetary policy. We could have a similar push-pull again, but in reverse. CB’s are trying to tighten monetary policy and get inflation down. Meanwhile, governments are trying to alleviate inflation hardship with deficit financed stimulus checks, which just makes the inflation worse. That’s how we get a scenario where inflation stays high longer than we expect and the upcoming winter will be unlike the ones before. As I said. This power tortures me. Throwaway comment about a crypto conference and this is where I go with it.
Self Financing Private Equity Portfolios
The second thing which struck me this week was the concept of retail investors building self financing private equity portfolios. Increased allocations to private equity and venture capital have been a huge trend for institutions, but now wealthy investors want in on it too.
I had been doing some work on a investment platform which creates small feeder funds for individual investors to enable them to pool their funds to access large well-known and exclusive private equity funds. In this platform’s literature they were explaining how the investor could commit to a $100,000 private equity investment, but only have to put down an initial $25,000 payment. The remaining $75,000 would be called in the future when the underlying private equity fund found good investment opportunities in which to deploy the money. Fine so far.
But then the platform explained how individuals should build up a portfolio of these different funds staggered over time. As the funds from 7-10 years ago come to the end of their investment life and return capital to their investors those gains could be used to go into the fund which you invested in 2 years ago, which now wants its $75,000. That’s the “self-financing” part. It’s fine if you don't have the other $75,000 now. The gains from your previous private equity funds will conveniently be ready for harvesting when the capital call comes. A series of J-Curves linked together.
Again, it all makes sense, but this triggered my spidey senses and sent me down the rabbit hole. You always hear about private equity and their ‘$3 trillion in dry powder’, but now I started to wonder. Is it really ‘dry powder’ or is it a bunch of investors who say “Yes, I’m good for the $3 trillion in the future. No. I don’t actually have the cash now, but I assume that by the time you need it in the future my other PE and Infrastructure fund investments will have matured and returned their capital to me. Or worst case I will sell something else in my portfolio to come up with the money.” And that my friends is a set up for ‘reflexivity’.
What’s so cool about Private Equity?
So why is there such a strong trend by institutions and now retail to increase allocations to private equity and venture capital? I see three reasons. First, there is an unspoken view that private equity is for the cool kids. The returns are higher because it is exclusive. Anyone can invest in public equities. But private equity and venture are a club, and you have to know the right people to be in the club. The in-crowd, like Stanford Endowment and Yale, hardly bother with public equities (just 25% allocation), while 65% of their allocation is to alternatives. It’s the Dave Swenson model from Yale and now everyone wants to do it.
When you read the Ivy League endowment annual reports they will all say they are increasing their allocation to private equity, venture and infrastructure to better capture the ‘illiquidity premium’ from private assets. For the top schools they will also say how they want to benefit from investing in their super smart alumni.
The second reason for the infatuation with private equity, and linked to the first, is that historically the returns have been higher. AQR did great research on this and the whole paper is good if the topic interests you. The headline is that going back to 1986 private equity has averaged 9.9%/year vs. 7.5% for the S&P 500. That’s an extra 2.3%/year net of fees over 30 years. That is persistent and substantial outperformance and why PE guys earn the big bucks. Interesting to note in column 5, and we will come back to this, that you could basically leverage a publicly traded small cap fund by 20% and get the same return stream.
The third attraction of private equity is the view it will do better in a downturn. With private equity there isn’t the short-term mark to market volatility you get with public equities and for institutions with liabilities this is important. Some institutions are willing to pay more for less stated volatility, even if they know the underlying businesses are the same. They know that if the private equity portfolio was listed it would trade the same way. There is also the view that in a downturn the private equity team can add value by improving operations. OK, but you can say the same thing about a public equity management team. The main selling point though for the mega funds being raised now is that if there is a recession it will just be a buying opportunity for all the ‘dry powder’.
Backing up this view that PE does better during downturns is that during the 2000-2002 and 2007-2009 downturns private equity funds didn’t have as large a drawdown as public equity funds (-27% vs -44%). Then when markets recovered the private equity funds snapped back faster than the public markets.
So it’s a win-win all round. If the economy stays good then private equity just continues to outperform as always. If there is a market crash, the PE fund goes down less, snaps back faster and has cash to buy on the lows. What’s not to like? Hence the record inflows.
My super natural ability knows this is all makes sense, but is not what’s going to happen this time. Here is how this winter will be different.
The valuation starting point it too high. The historical outperformance of private equity has been from buying businesses at a discount to public market valuations with attractive financing. But with all the money flowing into PE funds and the intense competition for deals valuations have been rising rapidly. This is not the heydays of the early 2000’s. If you invest in PE now you aren’t paying 8x EBITDA, you are paying 11x.
So you are paying 5%/year in fees to buy companies at the same price as you could get on the public market, but you are locked up for 10 years. AQR did great work on this and given today’s valuations they estimate future returns from private equity will be the same as public equity, but with less liquidity. Still, some may say that is fine, they don’t care if the returns are the same, they like the smoothed returns PE firms can report in a downturn, even if they aren’t really true.
Is now a good time to buy a leveraged small cap fund? Historically, PE returns have been higher, but the AQR guys ask the question if some of this is due to style difference. PE firms invest in companies that are on average smaller than public companies and small caps typically have higher than average returns just to compensate for the extra risk. PE firms also add leverage as part of the buy-out. This is why AQR compares PE returns to a public small cap fund but with 20% more leverage. So, if I told you we were going into a prolonged market downturn, would you think the best thing to do would be to go out and buy a leveraged small cap fund? Probably, not, but that is what the PE guys are telling you when they say PE will do better in a downturn. For a short 2 year sell off where the Fed comes in and rescues the market, fine, PE does well, but in a drawn out downturn (think years 3 and 4) the extra leverage PE firms are putting on their investments can create tremendous damage that will not be repairable. Which brings us to the dry powder.
‘Soggy powder’. The main selling point is that if there is a sell-off private equity funds which aren’t fully invested have the opportunity to buy on the lows and create great returns in the future. I think this could be partially true, which is why I call it ‘Soggy powder’ instead of dry powder. First, some of that unused cash is going to be used to repair the balance sheets of the earlier companies the fund has invested in. You will be using the money to bail out yourself. Second, with so much ‘dry powder’, it is going to take a while before you get really distressed prices. There might be many years of funds begrudgingly putting money to work into stressed businesses at prices that are still too high for what you are getting. This goes back to the crypto winter comment above. There is this complacency that we know how to handle a downturn. They are short and you buy the dip. Maybe go sit down with a gold mining CEO, share a whiskey, and have her tell you the long painful road out of an over leveraged balance sheet in a 10 year bear market.
Then there is also the question of whether the ‘$3 trillion in dry powder’ will even exist in a downturn. If all the investors were building ‘self financing private equity portfolios’ and the older vintage private equity funds can’t exit their positions because the market is bad, then there is no ‘dry powder’. In this case investors have to distress sell their existing PE investments in a secondary market to fund the capital calls from new funds. Or, maybe they have to sell something else in their portfolio at the wrong price to fund their private equity capital commitments and maybe at that distressed point they don’t want to put more money into private equity.
So where are the opportunities?
I still think gold looks good. Gold investors have been through a real winter, the chart looks good, and negative real rates are historically positive for gold. European banks are also a positive play on the scenario where short-term interest rates go up higher than we expect and stay higher for longer. Higher short-term rates will drive net interest margin expansion. The reverse of the last 12 years.
Finally, if you like private equity, create a private equity fund with real dry powder to go and buy out all the retail investors who went into private equity feeder funds and now learn there is no exit for a $100,000 position in a $50mn feeder fund of another private equity fund. These investors should take whatever price you give them because their original investment is permanently impaired and they won’t see the remaining 40% for over 10 years. That is what happens in a real winter.
Bonus chart of the week
Alright, gotta go. I am going to meet some friends later, but first want to get in a quick workout.
Have a good weekend!
Erik
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