Reality Check

This is a short-and-sweet post meant to get some thoughts down and possibly provide a (small) public service. In my line of work I’m involved in a bit of direct private equity investing. The typical acquisition target is a Main Street USA business with EBITDA somewhere between $500,000 and $2,000,000. These are profitable businesses but slow growers. We’re talking mid-single digit revenue growth here.

These businesses are worth something like 3x to 5x EBITDA (subject to negotiation, of course). It’s rare that the seller is financially sophisticated. The sale of the business is probably the only such transaction he or she will complete in a lifetime. So setting realistic expectations around pricing is one of the most important things to cover early in the process. If someone thinks he’s going to get a 10x multiple on one of these things it’s best to walk away early rather than waste everyone’s time and energy.

There’s a common argument unsophisticated sellers trot out to make the case for a higher valuation. It’s this:

What about my IP and intangible assets? Surely they’re worth something. You should be assigning more value to those things!

No purchaser takes this argument seriously. The fact of the matter is that value has been assigned to the IP and intangible assets. It’s in the earning power of the business.

Put another way, when you buy an operating business you don’t buy the tangible assets (property and equipment) separately from everything else. Same with intangibles. The costs and benefits associated with both tangible and intangible assets are loaded into the cash flow profile of the business. You don’t double-count them.

You Got To Pay To Learn

“A knowledge of cheating methods and the ability to detect them is your only protection against dishonest players in private games. It is for this reason that the most ethical, fastidiously honest card games are those in which the players are top notch gamblers, gambling operators, gambling-house employees and card sharpers. When they play together the game is nearly always honest. It has to be, because they play in an atmosphere of icy distrust, and their extensive knowledge of the methods of cheating makes using their knowledge much too dangerous. They do not cheat because they dare not.

In a money card game patronized by men and women who know little or nothing about cheating techniques, the odds are 2 to 1 that a card cheater is at work.”

John Scarne, Scarne’s New Complete Guide to Gambling (1986)

I came down with some horrible, vaguely flu-like illness recently. Happily, this at least coincided with the arrival of a print copy of Scarne’s New Complete Guide to Gambling. It’s more of a reference text than something you’d read cover to cover. What impressed me most as I leafed through its 800-plus pages was Scarne’s obsession with cheating. In addition to a full sub-section on methods for cheating at card games, nearly every discussion of a game includes a section on common methods for cheating. Rigged games, it seems, are the default state of the universe.

Scarne’s dismissal of carnival wheels is typical of both his logic and wit:

If you want to play carnival wheels for fun, you would be smart to consider that 25% to 50% of the money you wager on each spin is a donation; when you reach the total amount you wish to donate—quit playing.

As you’d expect, in addition to cheating, Scarne was fairly obsessed with edge. Of poker strategy, he writes:

There is one big secret, a Poker policy which, if put to use, will not only make you a winner at your next session but at most of them. It’s a policy that is practiced religiously by the country’s best poker hustlers. It is the only surefire rule that wins the money. It’s a simple rule: Don’t sit in a Poker game with superior players.

There are plenty of ways to apply this rule to investing. It’s well-worn ground in the context of the active/passive debate. I’ve got little to add there. So let’s talk about another application. Let’s talk about deals. Specifically, let’s talk about the “democratization” of deals—how increasingly, private equity and credit strategies are being pitched to wealthy individuals and their financial advisors as important, if not essential, additions to portfolios.

I’m hardly a low complexity, liquid asset teetotaler when it comes to portfolio construction. I happen to believe private market deals offer a rich opportunity set for value-added portfolio management by skilled professionals.

Why? Because we’re talking about a relatively inefficient, illiquid market where the participants are allowed to act on inside information. A real poker game. A wild west poker game, even. I suspect John Scarne would feel right at home at the helm of a PE or VC shop.

And wouldn’t you know it, the dispersion of returns for non-core real estate, private equity and venture capital managers is immense.

JPM_Alt_Manager_Disperion

What is the single most important thing that separates a top quartile manager from a bottom quartile manager?

Deal flow.

To continue with our poker game analogy, in the larger cap areas of public markets you can be reasonably certain the cards have been dealt fairly. Deal flow isn’t an issue there. In private markets, it’s just the opposite. Private markets are about card sharping. Pickup stacking. Riffle stacking. False shuffling. Nullifying the cut. Bottom dealing. There’s a reason certain big firms’ shticks are recruiting a vast army of consultants and partners, many of whom who operate at the nexus of government and business. There’s far too much money at stake here to leave these things to chance.

I have a friend who did a tour as a White House Fellow. Believe me when I tell you the deck is stacked. The big PE shops and consultancies are masters of the riffle stack.

So where does that leave us?

We can either learn to see the angles, or we can decline to play. When it comes to deals, there are plenty of hands not worth playing.

To take a simple example, let’s think about interval funds. These are private equity and credit deals packaged in a mutual fund-like wrapper that can more easily be sold to mass affluent clientele. The pitch is that you, or your financial advisor, can access the private equity “asset class” with more favorable liquidity terms, 1099 tax reporting, and so on. “Private markets for the rest of us,” so to speak.

What’s not to like?

I’ve had the opportunity to discuss these with a couple investment banker types. I always ask the same question: “How can we know the sponsors aren’t just dumping all their worst deals into these retail vehicles as an excuse to charge fees on the assets?”

The answer always comes back: “You can’t.”

And as anyone who’s ever invested in anything even remotely illiquid well knows, favorable liquidity terms are just, like, someone’s opinion. Read the docs! If stuff ever hits the fan, you’ll be gated and locked up like everyone else. No one cares about liquidity when times are good. Everyone wants liquidity when times are bad. The more desperately you want out, the more likely you are to find yourself trapped. This is a timeless axiom of risk management.

Oh, and there’s always the matter of performance evaluation. Deals are sold on the basis of IRR, but “you can’t eat IRR” (it doesn’t measure cash-on-cash returns). So remember to compare IRR to MOIC, and on top of that to look at everything in the context of your original capital commitment, ’cause there’s an opportunity cost to committed capital. You can go on and on with this stuff. We haven’t even gotten to trends for deal multiples, or the dispersion of those multiples across across market segments, or the leverage and coverage levels for those deals, or what any of that might mean for prospective returns…

…so, yeah, there are lots of angles in private markets.

How do you learn to spot them?

The same way you learn to gamble. By playing. By getting fleeced. By losing money. Scarne again:

After twelve hours of gambling, Fat the Butch found himself a $49,000 loser, and he quit because he finally realized something must be wrong with his logic. He was, later, part owner of the Casino de Capri in Havana, and when I told him it would need 24.6 rolls to make the double-six bet an even-up proposition, and that he had taken 20.45% the worst of it on every one of those bets, he shrugged his massive shoulders and said, “Scarne, in gambling you got to pay to learn, but $49,000 was a lot of dough to pay just to learn that.”

I’m not saying you shouldn’t play this game.

I’m saying if you choose to play, you better play to win, and you better be ready to take some hard knocks along the way. DO NOT DABBLE NAIVELY. Because the folks pitching you deals, and their competitors, are definitely playing to win. Winning is their business. I’m not talking narrowly about generating attractive net returns for investors. I’m talking about fee revenue and carried interest. Fee revenue and carried interest are the metagame here. And there’s far too much money at stake to leave that outcome to chance. Regardless of your net returns as an investor.

Since this is a Scarne-inspired note, I’ll give him the last word:

When you play cards, give the game all you’ve got, or get out; not only is that the one way on earth to win at cards, it’s the only way you and the rest of the players can get any fun out of what ought to be fun. You can’t play a good hand well if your mind’s on that redhead down the street or the horses or your boss’s ulcers or your wife’s operation. When you don’t remember the last upcard your opponent picked and you throw him the like-ranked card which gives him Gin, it’s time to push back your chair and say, “Boys, I think I have another engagement.”

Vulture Capitalism

640px-White-backed_vultures_eating_a_dead_wildebeest — Source: Wikipedia

Predictably, the Sears bankruptcy has attracted much wailing and gnashing of teeth around so-called “vulture capitalism” as practiced by hedge funds and private equity firms (here in the biz we use terms like “activism” or “distressed” investing). “Vulture” is of course used as a pejorative in these articles. Personally, though, I think practitioners should embrace the label.

In nature, vultures play an important role in ecosystems:

When vultures are unable to clean up the carrion in an area, other scavenger animals increase in population. The scavengers that tend to move in where vulture populations are low include: feral dogs, rats, and blowfly larvae. While these animals do help to remove carcasses from the landscape, they are also more likely to spread disease to human populations and other animals as well. In India, for example, the feral dog population increased significantly after vultures consumed cow carcasses poisoned with diclofenac, a painkiller. These feral dogs carried rabies and went on to infect other dogs and local people. Between 1993 and 2006, the government of India spent an additional $34 billion to fight the spread of rabies. India continues to have the highest rate of rabies in the world […]

[…] It is important to remember that even though the vulture species lacks the cute cuddly appearance of some endangered species, it is still a critical piece to a much larger, complex ecosystem. The world needs vultures to help control the spread of disease.

Likewise, vulture capitalists pick apart the corpses of dead and dying firms. Eventually that capital is recycled elsewhere in the market ecosystem.

Now, clearly this is not a pretty process. It is gruesome. It involves ruthlessly cutting costs; it involves firing good, hardworking people; it involves selling off assets and extracting cash instead of going through the “feel good” motions of reinvesting that cash into a dying enterprise. The firms that specialize in these activities are at the pointy end of Schumpeter’s “creative destruction.” It’s not exactly shocking that they’re unpopular with the general public.

But here’s the thing about “vulture capitalists.” They don’t feed on healthy companies. And there’s a good reason for this. Healthy companies are too expensive for distressed funds and buyout firms to get their claws into.

The popular notion that Sears, as a business, is dead money has been around since at least 1988. 1988! That’s thirty years. Three decades. Take a moment and think about that.

For thirty years now it’s been pretty clear the investment case for Sears rests largely on a sum-of-the-parts valuation of the real estate assets. There were very few possible worlds in which Sears would reinvent itself as a thriving retail business—particularly given brutal competition from Wal-Mart, Target, CostCo and others.

So when we talk about Sears we’re talking about the business equivalent of a sickly, dying wildebeest. Vulture capitalists consuming the carcass is simply the natural order of things. Even though hedge funds and private equity firms lack the cute, cuddly appearance of certain other market participants, they remain important pieces of a much larger, complex ecosystem.

Getting While The Getting’s Good

800px-Gluttony — Woodcut depicting the deadly sin of Gluttony, by Sebastian Brandt; Source: Wikipedia

Lately, investors have been gorging themselves on private equity. The Financial Times reports:

“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:

Verdad_Am_Affairs_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:

Tulips
Railroad stocks
The Nifty Fifty
Tech stocks
Hedge funds
Mortgage bonds
Florida real estate
Energy stocks
Bitcoin
Beanie Babies
Tesla stock

Big Piles of Money

Private equity is sitting on a huge pile of money. The line of investors runs out the door. In fact, private equity today reminds me a lot of hedge funds circa 2002-2005. It is the hot space. Flows have gone bananas. But will all of this money find a good home?

I am skeptical.

It is now a commonly held view that strong asset flows led to diminishing returns for hedge fund strategies over time. In general, too much money chasing limited opportunities is never a recipe for exceptional investment performance. What would otherwise be good investments become bad investments and what would otherwise be marginal investments become terrible investments.

As Seth Klarman puts it, everything is a buy at one price, a hold another and a sell at another. When a lot of money chases a limited opportunity set, prices rise. This may be good for today’s sellers but not so much for today’s investors.

I empathize with private equity investors because while there is a whole lot of money out there looking for a good home there are simply not many good homes available.

It is also now a commonly held belief that all the good companies stay private. I am not sure that is true when you have an enormous private company like Uber engaging in bizarre valuation gymnastics to manipulate its paper value. I am more inclined to argue that across the board, high valuations and easy money have turned what might otherwise be good companies into bad investments. Meanwhile, certain businesses go public that probably should not even exist if investors hope to see their capital again.

The title of this post is a play on the very well done NPR special, “A Giant Pool of Money.” (You should listen to it) The thrust of that piece was that artificially low interest rates drove investors to inflate a speculative bubble in US housing and related financial instruments, which in turn led to the global financial crisis of 2008.

Think how attractive a mortgage loan is to that $70 trillion pool of money.

Remember, they’re desperate to get any kind of interest return. They want to beat that miserable 1% interest Greenspan is offering them. And here are these homeowners paying 5%, 9% to borrow money from some bank. So what if the global pool could get in on that action?

There are problems. Individual mortgages are too big a hassle for the global pool of money. They don’t want to get mixed up with actual people, and their catastrophic health problems, and their divorces, and all the reasons that might stop them from paying their mortgages. So what Mike and his peers on Wall Street did, was to figure out a way to give the global pool of money all the benefits of a mortgage– basically higher yield– without all the hassle and risk.

So picture the whole chain. You have Clarence. He gets a mortgage from a broker. The broker sells the mortgage to a small bank. The small bank sells the mortgage to a guy like Mike at a big investment firm on Wall Street. Then Mike takes a few thousand mortgages he’s bought this way, he puts them in one big pile.

Now he’s got thousands of mortgage checks coming to him every month. It’s a huge monthly stream of money, which is expected to come in for the next 30 years, the life of a mortgage. And he then sells shares of that monthly income to investors. Those shares are called mortgage-backed securities. And the $70 trillion global pool of money loved them.

The above was reported in May 2008.

To date the underlying issue has not been resolved. As I write this the yield on the 10-year Treasury sits at 2.32%. Today the giant pool of money is not flowing into US housing and mortgage bonds. Instead it flows into private equity, high yield debt, leveraged loans and technology stocks. Plenty of it is eyeing cryptocurrencies.

But fundamentally it is doing the same thing it did in the mid-2000s. It is chasing returns.