Expectations v. Reality
One thing that never ceases to entertain me is when an institutional investor says s/he expects 3x from an emerging market private equity fund.
“We want to be compensated for the risk we’re taking.”
But how is that risk measured? People don’t seem to be using a Sharpe ratio, or some such analytic that disaggregates measures of alpha per quantum of risk.
According to Aswath Damodaran, the equity risk premia between developed and emerging markets have converged since the turn of the millennium. One could argue that investors should accordingly expect a lower premium from EM PE over time.
Using the spread between U.S. Treasurys and local sovereigns for a risk premium seems lazy. Private EM companies can be better credits than the countries where they operate, and actually have a lower risk profile than publicly listed companies (e.g., mining, oil & gas).
Also, it’s 2019.
Are we going to act as if many of these countries don’t have banks, and insurance companies, and mobile network operators now? There is a lot more competition, and a lot more capital scouring the landscape for deals (much of which is neither institutional nor residing with asset managers seeking PE-like returns).
Yet these markets are dynamic, and exciting, and they present an opportunity for investors to build great businesses. It’s not like the pass-the-parcel, value-transfer game in developed markets.
To be clear, there absolutely will be EM deals and perhaps some funds that deliver ≥ 3x net DPI at the end of their life. But if you’re an institutional investor investing in institutional-quality funds, what are the odds that you’re going to pick one of these winners?
Low. In all likelihood, you’re probably going to wait until the firm has a track record and built up its back office to satisfy your trustees.
By then, said firm will have scaled and begun investing in larger companies, and the economies and sectors in which they’re investing will have evolved materially.
All of these behaviors are reasonable. But the idée fixe of getting 3x is not.
If you’re going to wait for managers and markets to institutionalize and de-risk, then you should be willing to give up some of the upside. You don’t deserve it.
How realistic is the expectation of 3x, anyway?
Take a look at CalPERS’ experience (see below). Of the 268 PE funds in its portfolio (excluding vintage years 2016-18), only two funds clear the 3x hurdle.
Only 36 funds (~13%) have delivered at least 2x. Meanwhile, 80% of the funds sit between 1x and 2x, and nearly half are valued at less than 1.5x.
And lest we forget, these are with PE firms’ marks …
We could tie ourselves in knots in a discussion over the suitability of CalPERS’ portfolio as a data set, but a bogey of 3x in EM just seems unreasonable.
New rule: stop being unreasonable.
Investors often talk about the need for private equity firms to harvest an illiquidity premium — an incremental return above that generated in public markets.
The idea makes sense …
… when public markets are liquid.
But what happens when an exchange can’t absorb trading volumes? What if it fails in its job of serving as a market maker?
You should probably ask the people who tried to sell shares of Jardine Matheson Holdings Ltd. — one of the largest listed companies on the Singapore Exchange — at the market’s open on January 24th.
Shares sank just before the regular session began, with about 167,500 changing hands at just $10.99, compared with Wednesday’s close of $66.47. Jardine, the flagship investment firm of a 186-year-old conglomerate, soon recovered from the $41 billion wipeout and ended up closing 0.5 percent higher.
Selling at an 83% discount seems … not to be a great advertisement for the benefits of liquidity.
CMC Markets Singapore analyst Margaret Yang Yan is a bit more candid:
This kind of stupid mistake shouldn’t have happened in an established stock exchange. It is the largest exchange in south-east Asia … It’s ridiculous.
Also ridiculous: not putting in a limit order?
This markdown never would have happened if Jardine Matheson were a PE portfolio company. But then …
The trickle of exits / distributions from EM PE funds is a fact of life. We often hear about structural reasons for this logjam — the depth of local capital markets, for example.
But, what if it has little do with EM, and more to do with dealmakers’ biases? What if (most) everyone’s actually good investing?
In “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors,” a group of researchers analyzed 783 institutional portfolios with an average portfolio value of ~$573m. The dataset included 4.4 million trades between 2000-16.
Say the authors:
We document a striking pattern: while the investors display clear skill in buying, their selling decisions underperform substantially. Positions added to the portfolio outperform both the benchmark and a strategy which randomly buys more shares of assets already held in the portfolio … In contrast, selling decisions not only fail to beat a no-skill strategy of selling another randomly chosen asset from the portfolio, they consistently underperform it by substantial amounts. PMs forgo between 50 and 100 basis points over a 1 year horizon relative to this random selling strategy.
Basically, one way to enhance performance is to become a better seller.
Maybe this could be a new skillset to hire for? Someone who sits at the table during portfolio reviews and offers constructive comments, such as, “Maybe we should sell [company].”
Or someone who walks around the office offering a helpful feedback.
Deal Gal: This promoter is a pain in my rear. The board meetings are a shambles. He won’t listen to anything we have to say.
New Guy: Hmmm … [pauses for dramatic effect and adopts hipster podcaster voice] Have you thought about selling it?
Deal Gal: But he knows what he’s doing! If we hold on to this company for another 18 months we could be looking at a 3-bagger.
In Portico’s first research piece, I noted that the growing costs of compliance were taxing the bandwidth of smaller fund managers, and regulatory complexity was making it more difficult for firms to raise capital.
[You can envision billionaires at mega-cap firms pulling up the drawbridge behind them as regulation stifles competition and entrenches their firms’ market position.]
Well, Kirkland & Ellis sent out an update about some recent Delaware decisions regarding text messages, personal emails, and corporate litigation that brought home how absurd the world has become.
Chancellor [Andre] Bouchard added that he often finds texts to include especially probative information, particularly when covered in emojis. In a recent decision (Transperfect), he attached significance to a smiley-face “emoticon” included in one of the party’s texts as evidence of the malign intent of the sender.
Look, I am out of my depth when it comes to the legal implications of emoticons. But what’s the over / under — in months — before a DDQ contains responses to one of the following questions:
- What is your policy on emoticon use?
- Have you disabled controversial emoji across all devices, messaging, and email clients?
- Have you staffed up your emoji compliance function with digital natives who can discern malignant intent amongst the extant universe of 2,500+ emojis?
Blackstone Quits Africa
No surprises here. Secondo Il Sole 24:
Il problema, sembra, è che Blackstone non ha trovato grandi operazioni da finanziare [emphasis added]. E la competizione cinese ha complicato la situazione. Anche KKR incontrò difficoltà simili tanto da smantellare nel 2017 il team di persone dedicate al continente africano e vendere il suo unico asset in quella regione, un produttore etiope di rose.”
Inspecting the Books
Catalyzing private capital is one of the core missions of the development finance institutions. Oftentimes, in EM private markets, this takes the form of seeding local managers and building them into institutional-quality firms (see intro).
But, what if there were another way? One that didn’t take so long. One that evoked the spirit of a place, and its people, and it propelled you to book a ticket to visit that manager in Poland or wherever.
Then you might learn about the 1 million family-run businesses that are in need of succession planning. Or the scarcity of expansion capital in a market of ~ 40 million consumers.
You might put down some Żywiec and pierogi, and get lost in Warsaw.
You might, actually, feel alive.
Manager visits wouldn’t be like those depressing trips where you eat Panda Express in a Holiday Inn Express, and the view out your window is of a half-vacant parking lot and a highway.
The EBRD has released the longlist for its 2019 Literature Prize, and until this moment I didn’t think I wanted another job, but I will read books and tell you which ones I like if you pay me to do so.
It’s a pretty cool looking collection from EBRD’s geographies. Hope you find something you like.
From the Bookshelf
For the first time in my life I understood that the sense of poverty is not the result of misery but of the consciousness that one is worse off than others.
Providence is no substitute for prudence.
— Jan Karski, Story of a Secret State (Houghlin Mifflin Co.: 1944)
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