I’ve always been a fan of the old saw, “there are no free lunches.”
Not too long ago I heard this re-framed as “someone has to pay for lunch, and I don’t want it to be me.” I much prefer the second version. It underscores the fact that you can’t destroy risk. You can only lay it off onto someone dumber more willing to bear it than you.
Elad Ossadon and Noam Szpiro, who work in software engineering, have become referring pros. In 2016, they created a website called VC Fund My Life, which catalogs discounts and freebies. When a user signs up for the startups listed, they get a referral bonus, often altered by a buzz of their phones.
Mr. Ossadon said before he started the site, he was pushing startups with bonuses on anyone he knew.
“Friends that visit here, move here—friends of friends, random people,” he said. His reward: free burgers and Thai food delivered by startup Postmates and “months over months” of free housecleanings from on-demand services company Handy.
In all, Mr. Ossadon and Mr. Szpiro estimate they have earned over $10,000 in referral credits, although many startups have started to put an expiration on the credits. “The challenge after a while became, can you use your credits before they expire?” said Mr. Szpiro, in a gray knit shirt acquired with the aid of referral credits from online retailer Everlane.
This is one of those “squishy” data points worth paying attention to. Low interest rates encourage investors to move into “long duration” equity investments such as biotech, cryptocurrency and (of course) venture capital. Even with all the talk we hear about “rate jitters” these days, capital remains cheap and cash incinerators are objects of envy.
“The current speed of fundraising is in my experience unprecedented,” said Jason Glover, a London partner at Simpson Thacher, the law firm. “[Private equity groups] are keen to take advantage of the unusually benign conditions, particularly in anticipation of a change in market conditions when fundraisings may become significantly more difficult.”
But Mr Glover, who has been involved in private equity fundraising for more than 25 years, said investors are eager to park their cash in top-performing funds. “Investors are keen to deploy increasing amounts to private equity and with many of the top funds massively oversubscribed, their only way to secure a commitment is to act quickly before those funds are sold out,” he said.
Private equity funds have also gained traction with investors as other asset classes, like hedge funds, have underperformed, said Warren Hibbert at Asante Capital Group. He said: “The private equity market today provides a unique product which is very difficult to kill, unlike hedge funds. It’s very difficult to lose money in a private equity fund.”
Part of the public service I attempt to provide on this blog is drawing attention to screaming red flags when I see them. As far as screaming red flags go this is a pretty good one.
Private equity is simple in principle and is first and foremost an exercise in financial engineering:
Step 1: Buy cheap company.
Step 2: Add gobs of debt.
Step 3 (optional, if desired): Cut expenses to boost free cash flow.
Step 4: Flip the levered entity at a higher valuation.
The problem private equity investors face today is that they are buying into funds based on past performance that is not likely to persist. The reason? Valuations.
Remember, per the above steps private equity works the same as flipping houses. You need a cheap entry price, low financing costs and stupid willing buyers on the other side. As entry valuations rise, the bar rises on the back end. You need to find progressively dumber more optimistic buyers to exit the investment and earn an attractive return.
Dan Rasmussen of Verdad Capital has written and spoken extensively about his firm’s in-depth research into private equity returns. In a piece written for American Affairs, he discussed the negative impact of higher entry valuations at some length:
This is more troubling than most market observers understand. Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy. The importance of valuation to returns is controversial but key to understanding the asset class, so it is worth looking at the issue from a few different angles.
The first approach is to look at PE deals and compare returns to purchase price. One PE firm did just such an analysis and found that over 50 percent of deals done at valuations of more than 10x ebitda lost money and that the aggregate multiple of money was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors).
The second is to compare the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between purchase price and vintage year return, a strong inverse relationship.
The third is to look at PE-backed companies that IPO. My firm, Verdad, looked at every company taken public in the United States and Canada by a top-100 PE firm since the financial crisis, a data set of 195 IPOs with an aggregate ebitda of $66 billion and an aggregate market capitalization of $728 billion. The average company in this data set went public with $4 billion in market capitalization, traded for 17x ebitda, and was 21 percent leveraged on a net debt/enterprise value basis at IPO. We segmented these IPOs by valuation at IPO. We divided the universe into three buckets: companies that went public at less than 10x ebitda (about 20 percent of companies), 10–15x ebitda (about 20 percent of companies), and more than 15x ebitda (about 60 percent of companies). According to our research, the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed.
Included in the article is this chart comparing historical valuation multiples:
Source: Verdad Capital via American Affairs
As for Mr. Glover’s assertion that “it’s very difficult to lose money in a private equity fund,” here is a list (not comprehensive) of assets and strategies that wore that mantle at one time or another:
New Jersey’s treasurer said on Thursday she will increase the expected rate of return for the state’s struggling public pension system from 7 percent to 7.5 percent, then lower it again over time.
The switch to a higher assumed rate means that the state, and participating local governments in New Jersey, will for now escape the higher costs that arise when investment return assumptions are lowered.
The savings come at a fortuitous time for new New Jersey Governor Phil Murphy, who took office in January and is facing a shortfall ahead of his first budget proposal in mid-March.
The higher rate will save about $238 million for the state and more than $400 million for local governments in the near term, according to the office of Acting State Treasurer Elizabeth Maher Muoio.
Color me gobsmacked. Here is a translation into plain English:
We know that our current return assumption is unrealistic. But, if we lower it outright we are going to have to make large contributions we can’t really afford (we are only 49 percent funded as it is). So we are going to tell a teensy weensy little white lie, and pretend returns will be higher for a while. And eventually we will fix the numbers. It will all work out in the end. Trust us.
Where is one to begin with something like this?
With the fact that New Jersey’s treasurer is OPENLY FUDGING THE NUMBERS?
How about some healthy skepticism regarding whether a bunch of politicians will ever adjust the numbers back down to where they belong if it means a public outcry over unfunded liabilities or higher taxes?
Or maybe the troublesome fact that only 50% of projected liabilities are funded?
Puerto Rico should be instructive where these underfunded state and municipal pension plans are concerned, both in terms of the root causes of the problems and the difficulties inherent in closing massive budget holes. This is not likely to end well for New Jersey.
Markets are ecosystems. And like any ecology, markets can come to favor organisms with certain traits over arbitrary time periods. In the natural world, dinosaurs flourished when the global climate favored their biology. Then, quite suddenly, that changed. National Geographic tells it like this:
Scientists tend to huddle around one of two hypotheses that may explain the Cretaceous extinction: an extraterrestrial impact, such as an asteroidor comet, or a massive bout of volcanism. Either scenario would have choked the skies with debris that starved the Earth of the sun’s energy, throwing a wrench in photosynthesis and sending destruction up and down the food chain. Once the dust settled, greenhouse gases locked in the atmosphere would have caused the temperature to soar, a swift climate swing to topple much of the life that survived the prolonged darkness.
This is not so much different from those who got wiped out holding large positions in XIV. Short volatility strategies thrived in a market environment that for years has favored long duration assets (long term bonds, high growth stocks, cryptocurrencies) and dip-buying any market decline. When the market environment changed, suddenly and violently, the short volatility trade blew up. Years of gains vaporized in a single day.
Over the past couple of years I have begun to believe there are tremendous benefits to viewing markets through an evolutionary and/or ecological lens. I think this helps you focus on a range of variables impacting the markets, versus wearing blinders that limit you to valuation, momentum, or whatever it is you consider your “thing.” So when a particular asset class catches a strong bid, here are some things I consider:
If this is a cash flow producing asset, what is the relationship between the intrinsic value of the cash flows and the market price? For stocks it is not especially difficult to use the market price and a simple DCF model to derive a market implied IRR. For bonds just check the yield to maturity, yield to call, yield to worst, etc. This gives you an idea of how investors are pricing risk.
Who is driving flows into or out of a sector or asset class? Mutual funds look at the world differently from hedge funds, which look at the world differently from banks and insurance companies. Each of these players has different objectives and constraints, which will impact their behavior as market conditions change.
Are the players driving flows into the asset weak or strong hands? Retail investors are the weakest hands in the markets. I consider many mutual funds weak hands also (depends on the fund family). Mutual fund flows are driven by retail investors and their financial advisors, who are notorious for chasing performance.
How highly levered are the players driving flows into the asset? Leverage can drive extraordinary returns, but it also creates fragility. When deleveraging events occur, prices can collapse suddenly. Many of the short volatility players who got blown up recently didn’t understand the magnitude of the leverage embedded in their positions.
What exogenous factors are driving flows into this asset class? Is an asset in demand due to expectations for low interest rates, low inflation, or other macroeconomic variables? Macro conditions are fickle, and human beings are notoriously poor forecasters.
The most fragile market ecology is one where weak hands are using leverage to play some exogenous variable with known unstable or mean-reverting properties. From this perspective, systematically shorting volatility was stupendously risky–a form of Russian roulette. A large number of retail investors were trading instruments (volatility linked ETPs) with significant embedded leverage, placing a massive directional bet on low rates, low inflation and market momentum.
A market ecology I believe is extremely fragile, but hasn’t blown up yet, is high yield debt. This is an asset class that is highly leveraged by definition, and has attracted massive flows from yield-starved investors. Strong flows have pushed prices up to the point where future expected returns are dismally low, and protective covenants are the weakest on record. Perhaps worst of all, there is a liquidity mismatch between the ETPs (HYG, JNK, etc.) providing investors with easy access to high yield debt and the underlying high yield bonds. For a preview of what happens when a liquidity mismatch meets a stampede for the exits, refer to Third Avenue Focused Credit.
I was reading a cryptocurrency report from Goldman Sachs this morning and stumbled upon the following chart:
Source: Goldman Sachs
Now, put those dates in the context of the Bitcoin price action (which I think is a fair approximation of investor appetite for cryptos more generally):
Source: Bloomberg / coindesk
This speaks to a corollary of The Golden Rule:* The market supplieth what investors doth demand. If people are willing to throw billions of dollars at crypto lottery tickets, you can bet they will find an ample supply of coins and tokens to invest in.
Another, perhaps more intuitive way of thinking about this is that “easy” money attracts “investors” like blood attracts sharks. The sharks come swimming, and if there is enough blood in the water a feeding frenzy will ensue.
In ecology, a feeding frenzy occurs when predators are overwhelmed by the amount of prey available. For example, a large school of fish can cause nearby sharks, such as the lemon shark, to enter into a feeding frenzy. This can cause the sharks to go wild, biting anything that moves, including each other or anything else within biting range. Another functional explanation for feeding frenzy is competition amongst predators.
In boring old non-tokenized finance, this dynamic drives the credit cycle. Suppliers of capital get good deals when capital is scarce. They get crap deals when capital is plentiful. When capital is plentiful, and investors are overly trusting, capital ends up in the hands of miscreants and value destroyers (though admittedly, many value destroyers are well-intentioned). In fact, driven wild by greed and vying for deal flow, investors compete aggressively to offer capital on favorable terms to miscreants and value destroyers.
What kind of deal do you suppose you are getting when you exchange cold hard cash for a token with no protective covenants, that gives you no claim on equity or future cash flows, and which may not even exist yet?
Source: Wikipedia
* The Golden Rule: He who hath the gold, maketh the rules.
It gets worse. The indicative values for SVXY and XIV had fallen over 90% when they finally printed for 2/5. Word on the street is that the collapse of XIV may have blown a $500 million hole in Credit Suisse’s balance sheet (at pixel time Credit Suisse was the largest holder of XIV, owning about 4.8 million shares).
No one who lost money in this trade has anyone to blame but themselves. The risks were well known. And any time you see stories like this, you know you’re looking at a disaster in the making.
UPDATE: News reports indicate Credit Suisse is fully hedged for their XIV exposure.
“I started with 50k from my time in the army and a small inheritance, grew it to 4 mill in 3 years of which 1.5 mill was capital I raised from investors who believed in me,” Lilkanna explained, adding that those “investors” were friends and family.
“The amount of money I was making was ludicrous, could take out my folks and even extended family to nice dinners and stuff,” he wrote. “Was planning to get a nice apartment and car or take my parents on a holiday, but now that’s all gone.”
Credit Suisse said the closure of the VelocityShares product, whose valued peaked at $2.2bn on January 11, had “no material impact” on the group and a Credit Suisse insider said its exposure was “fully hedged”. The Swiss lender was listed as the biggest holder of the note, but the insider stressed that the bank did not hold any of the product’s notes on its own behalf, rather they were held in custody for clients. He also stressed that the notes were not sold through Credit Suisse’s private bank.
Still, there could be some repercussions for the bank, which is midway through a restructuring plan designed to make it less dependent on risky investment bank activities. “The reputational issue is more tricky and it can’t be comfortable having put clients into a product that has imploded like this,” said Piers Brown, an analyst at Macquarie. “They’ve indicated it was mainly sold to hedge funds so I guess you’d say they are sophisticated investors who knew the risks. However, they’ve also talked of the opportunity they see in selling more structured products to their private banking clients. This might raise a few question marks over that idea.”
UPDATE #6: The vol shorting ex-Target manager turned day trader apparently survived the blowup. If this is true, I have to give the guy credit for managing risk in his book.
“Volatility is about fear… but extreme tail risk is about horror […] It is not the first act of the horror movie when people start turning into zombies… it is the end of the second act when the hero realizes he is the only person left not a zombie.”
You should read the whole talk. It is fascinating and informative. Bill Nygren is a well-regarded mutual fund manager. This post isn’t meant to impinge on his intelligence or skill (your humble blogger is acutely aware he is a nobody). What this post is meant to show is how some of the most capable investors in the world have been impacted by very low interest rates.
We know from prior analysis that the riskfree rate of interest has varied dramatically over the last 50 years, and that current rates plot on the low end of the historical range. Here is a visual from my discount rate post:
Data Sources: Aswath Damodaran & Michael Mauboussin
So is a 100 bps upward adjustment to the market yield really giving you a conservative hurdle rate?
This is the critical difference between an investor concerned with relative performance versus a benchmark index and an investor concerned with absolute performance that will compound capital at attractive rates over time. Ambitious absolute return goals should be accompanied by high return hurdles. When a hurdle is set at “bond yield + x bps” in a low rate environment it may underprice risk.
One of Ireland’s richest entrepreneurs has embraced an aggressive new version of an already esoteric form of junk bond, highlighting the level of risk that debt investors are willing to tolerate as they seek higher yields in hot credit markets.
The $350m “super PIK,” or payment-in-kind bond, raised at the end of last week will pay a dividend to a group of shareholders in Ardagh Group, a one-time small Irish glass bottle maker that has grown in the past two decades into one of the world’s largest metal and glass packaging companies.
PIK refers to bonds or loans that can pay their interest with further debt rather than cash. This means the size of the debt can balloon quickly and leave lenders with steep losses if the underlying company is not able to handle the growing burden.
No, your eyes do not deceive you. The company raised a $350mn bond issue that gives it the option of paying coupons with IOUs instead of cash. So it can pay insiders a dividend.
While Ardagh listed on the New York Stock Exchange last year, 92 per cent of its shares are held privately, with its billionaire founder and chairman Paul Coulson the largest shareholder. It is these private shareholders that are receiving the dividend. “In plain terms, the use of proceeds is essentially providing a ‘margin loan’ to legacy shareholders,” noted analysts at credit research firm CreditSights.
Here is the cap structure, if you are interested in a quick round of Spot The Suckaz:
Source: FT
And where exactly did this boondoggle price?
Despite its risky structure, the PIK bond sale drew roughly $2.5bn of orders, said a person close to the deal. This allowed it to ultimately price with a yield of 8.75 per cent, below the 10 per cent initially marketed. An older PIK dollar-denominated deal sold by the company in 2017 currently trades with a yield of 6 per cent.
Yeah, I know, it’s all anecdotal evidence. You can’t time the market or the credit cycle. Blah, blah, blah. Nonetheless, I vaguely recall an old Warren Buffett saw… something about when to be fearful and when to be greedy…
In recent posts (here and here) I explored my view that today’s markets are systematically mispricing risk. My analysis isn’t exactly rocket science. So why does this mispricing persist? Why does everyone shrug their shoulders and say, “well, there is no alternative,” versus simply dialing back their exposures or hedging out some of the tail risk? At the very least, investors could increase the discount rates used in their valuations to correct for ultra-low riskfree interest rates and build in a greater margin of safety.
So why don’t they?
I would argue that more than anything, it is business and political pressures that drive this behavior. Importantly, I don’t believe this mispricing of risk is irrational. Rather, I believe decisions that seem rational on a micro level have led to irrational behavior in the aggregate. Investors are simply behaving how they are incentivized to behave–as a herd.
Here are my reasons:
Institutional investors must remain invested. If you are a mutual fund manager or a hedge fund manager or venture capitalist, good luck explaining to your investors why you are sitting on a portfolio that is 40% cash. Many investors are loathe to stick with a manager who sits on a cash hoard for an extended period. Particularly in a buoyant market where cash will drag on returns. There is a sound rationale for this: the investor is perfectly capable of allocating to cash or hedging market risk on his own. Why pay some asset manager fees to sit on cash? While this makes plenty of sense from a business perspective, it makes no sense at all to an investing purist. The purist takes risk when the market is rewarding her for it and pares risk when the market is not rewarding her for it. Portfolios should be positioned more aggressively when markets are dislocated and prices are bombed out. They should be positioned more conservatively when valuations are high and expected returns are low.
Institutional investors are afraid to look different from their peers. Career risk drives a great deal of behavior in financial markets. It is the reason so many mutual funds look so similar to their benchmarks. This positioning makes no sense to a purist concerned with absolute returns. Yet it is perfectly rational for the mutual fund manager who will be fired if he drops into the fourth quartile of performance for a trailing 3-year period. Likewise for pension funds and endowments with trustees who may be penalized politically for contrarian positioning.
All investors have return hurdles to meet. If you are an individual or pension fund there is a certain rate of return that will allow you to fund your projected future liabilities. If you are an endowment or foundation there is some spending rule governing portfolio withdrawals, usually based on long-run capital market expectations. Altering these hurdles is a big deal. Reducing expected returns means pensions and individuals will have to save more to fund future liabilities. Endowments and foundations may have to cut financial support for certain programs. This can be psychologically devastating for individuals and extremely embarrassing for institutions. It is a powerful incentive for investors to take a “glass half full” view of the future, even if it is ultimately self-deluding and counterproductive.
Perhaps the most significant advantage you can get in the markets is what Ben Carlson calls organizational alpha. Put simply, this is the flexibility to do what others can’t, or won’t, as a result of business and political pressure. It is the freedom to switch off the autopilot and deviate from the pre-established flight plan.
