Illusions and Delusions

Steve Jobs once said, “You can’t connect the dots looking forward; you can only connect them looking backwards.”

There’s a lot of wisdom in that nugget, whether applied to issues of a spiritual or temporal wavelength.

It’s also relevant to quotidian things, such as deciding which book to read. For instance, in the decade since I left SAIS, apart from a methodical reading of the Ancient Greek classics, I’ve approached my bookshelves with no real theme or objective in mind.

At least, that’s what I thought.

Whilst reading William Manchester’s droll book on the Medieval mind last week, however, I experienced an epiphany that revealed a pattern amongst the cornucopia of titles.

All these years, most of the most-enjoyable books have dealt with the theme of illusions and delusions.

They covered what Adda Bozeman, in her magisterial Politics and Culture in International History, refers to as the gap between image and reality.
(h/t Ben Welch for the recommendation).

Or, as Barbara Tuchman described it, the periods “when the gap between ideal and real becomes too wide, [and] the system breaks down.”
(See A Distant Mirror and The Proud Tower).

Basically, history is littered with episodes when the bottom falls out of everything. Foundational myths, religious and political institutions, social orders, scientific hypotheses — all have cratered in the face of discovery, new knowledge and shifting conditions. They prove to have been illusions and delusions.

Lest we think that these gaps between myth and reality are confined to the distant past, consider this remark from Alan Greenspan in 2007 (as quoted in Adam Tooze’s Crashed):

[We] are fortunate that, thanks to globalization, policy decisions in the U.S. have been largely replaced by global market forces. National security aside, it hardly makes any difference who will be the next president. The world is governed by market forces.

Oops.

Or, consider the astonishing scale and duration of the fraud that was Theranos. John Carreyrou’s riveting Bad Blood, which deservedly won the 2018 FT / McKinsey & Co. Business Book of the Year award, is replete with illusions and delusional people — including a credulous board comprised of national security cognoscenti.

Or, revisit our January newsletter (“Bulls on Parade”) in which GMO’s Jeremy Grantham and KKR’s Henry McVey were bulled up on EM. I was too. Illusion! Delusion!

If it’s any consolation, an insight from Jobs’s quote is that it’s virtually impossible to measure the size of the gap between myth and reality in real time.

But man, secondo me, it really does feel like we’re living through a period when the gap between image and reality is wide and widening, and a trapdoor is beneath our feet.

I wonder, though. Which of the foundational beliefs in EM private markets will prove to have been illusions and delusions?

A few motions to debate with yourself and others:

  • There is an abundance of EM companies ripe for PE investment
    (h/t Nadiya Auerbach).
  • U.S. PE will outperform EM PE over the next decade.
  • LPs that have committed to mega-cap Asia / China venture will do well over the next decade.
  • “Impact investing” will continue to be a viable asset-gathering strategy for industrial-sized GPs if / when the yield on the U.S. 10 Year climbs north of 5%.

Anyway, our second son is arriving imminently, so this is Portico’s last newsletter for 2018.

A humble request: if you value our monthly(ish) dispatch, please share it with friends and colleagues. They may sign up for free at this link, and read previous editions here.

Once again, we’re going to make a charitable contribution for each new (human) subscriber we get between now and 30 December. We’ll be donating to Room to Read, a nonprofit active in Africa and Asia that focuses on literacy and gender equality in education.

Health and happiness to you and yours.

Alla prossima,
Mike

401(k)s — The Final Frontier

Private equity is one step closer to accessing the $5.3 trillion 401(k) market in the United States.

The Committee on Capital Markets Regulation has released Expanding Opportunities for Investors and Retirees: Private Equity, a study that provides the intellectual grist for legislative changes that would democratize access to direct investments in PE / VC funds.

I’m of two minds on this issue. Like, of course people should be able to invest in private investment funds. But on the other hand, there just aren’t that many great PE funds that merit one’s investment. Seems like a poor set-up for success.

Moreover, there are limits to PE’s absorptive capacity. For example, according to PitchBook, U.S. PE funds raised $275 billion in capital in 2017. If PE captured just 3% of the current 401(k) market, that’s an incremental $160 billion. Would a 60% increase in capital have a negative impact on returns?

Admittedly, this compares stocks to flows; but it’s worth asking just where all this capital would go. One thing is certain: it would generate a lot of fee income for managers.

It may have been my reading of it, but the study seems to pain itself on using historical performance data to make the case that private equity’s outperformance of public markets is akin to a law of nature. A tad overdone, in my opinion. Private equity is a market of managers; and recent research demonstrates that the persistence of fund managers’ performance is declining.

Honestly, how are retail investors going to select top-quartile managers when professional LPs fail to do so on a regular basis?

The reality is that they won’t. They’ll likely invest in the name-brand mega-cap firms that excel at gathering assets. The best-performing GPs don’t need — or want — Mom & Pop’s money.

Cui bono?

Future Fund

Steve Byrom — head of PE at Australia’s A$150 billion Future Fund — has something to say:

At a big picture level, this asset class is becoming less attractive … Business models aren’t sufficiently differentiated because of the number of GPs in the ecosystem and the amount of capital competing for a reasonably small number of bidders.

Great time for retail to jump in!

Norway on Governance

Norges Bank Investment Management made a couple appearances in the newsletter this year, most notably for calling out private equity’s lack of transparency as a principal reason for their decision not to invest in it.

And since governance has been a key theme this year (and will be at least through Q1 ‘19), I was pleased to see that Norges Bank has released three position papers on key governance issues:

Social Capital

Chamath Palihapitiya — Founder and CEO of Social Capital + Owner of the Golden State Warriors — is an outspoken guy whom I’ve enjoyed listening to and reading over the last few years.

There was a bunch of hubbub in recent months about the exodus of employees from his firm, as well as his decision to transition from a fund structure to a holding company that will invest from its own balance sheet. I don’t know what’s fact or fiction. I don’t really care.

But since the firm is now a holding company, Palihapitiya is emulating Warren Buffett and releasing annual letters. His first letter provides a dour view on U.S. venture capital as an industry, which he colorfully describes as a “multilevel marketing scheme.” It’s worth reading. His cynicism is crisp, refreshing, and effervescent, like a chilled flute of pignoletto.

In the letter, he asserts that “the demands of innovation are going up;” it’s a conclusion that I’m inclined to believe. As I wondered aloud last month, “maybe founders with vision are the scarcest thing around.”

Palihapitiya closes with a cheeky comparison of Social Capital’s performance over its first seven years vis-à-vis Berkshire Hathaway’s. The devil’s in the footnotes, but I must say: hubris is not a good look.

From the Bookshelf

[T]he political and philosophic history of the West during the past 150 years can be understood as a series of attempts — more or less conscious, more or less systematic, more or less violent — to fill the central emptiness left by the erosion of theology … the decay of a comprehensive Christian doctrine had left in disorder, or had left blank, essential perceptions of social justice, of the meaning of human history, of the relations between mind and body, of the place of knowledge in our moral conduct …

[This] nostalgia [for the absolute] — so profound, I think, in most of us — was directly provoked by the decline of Western man and society, of the ancient and magnificent architecture of religious certitude … Today at this point in the twentieth century, we hunger for myths, for total explanation: we are starving for guaranteed prophecy …

It was a deeply optimistic belief, held by classical Greek thought and certainly by rationalism in Europe, that the truth was somehow a friend to man, that whatever you discovered would finally benefit the species. It might take a very long time. Much of research clearly had nothing to do with immediate economic or social benefits. But wait long enough, think hard enough, be disinterested enough in your pursuit, and between you and the truth which you had discovered there will be a profound harmony. I wonder whether this is so, or whether this was itself our greatest romantic illusion?

— George Steiner, Nostalgia for the Absolute (Anansi Press: 2004)

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

 

The Work

September is upon us, and Portico is marking the beginning of its third year in business. We’re not popping champagne bottles to mark the occasion, but it’s pretty dope to be here plugging away. After all, roughly one-third of U.S. businesses close within their first two years.

It’s not all peaches and cream, of course. EM PE is a hard-driving, competitive industry — and it’s one going through hard times.

During a recent discussion with a client, I shared my reservations about launching an advisory firm that caters to a shrinking industry.

“One of the challenges of managing a firm in this business,” he replied, “is that the downcycles are so brutal. Good people get discouraged waiting for the cycle to turn, and they walk.”

If the figures in this EM PE talent management survey are to be believed, fatigue with the industry explains more than 20% of staff turnover. Boy, do I feel that fatigue sometimes — and I’m not even working in an EM PE firm.

All that said, Portico’s still profitable with zero debt. We missed our (über-) aggressive revenue target, but that’s okay. It was at odds with two other goals I had for the year: launching a product (accomplished, but a serious time commitment) and making sure we had happy customers.

On the latter, we conducted a client survey over the summer to gauge our progress. The findings were favorable: all of our clients were “very satisfied” and our Net Promoter Score is maxed out at +100.

The other encouraging indicator is that all of our new clients have come through referrals.

Portico-Net-Promoter-Score

As for new targets, I experienced an epiphany last month. It came to me shortly after I’d achieved one of my personal goals for the year (attaining two stripes on my belt in BJJ). The epiphany was this: the stripes didn’t matter. I still get crushed, sometimes even by people with less experience. The value (and the pleasure) is in the work itself.

So, no hard targets for year three. I’m going to focus on doing the work and being helpful to others.

Entrepreneurship is way overhyped, but the liberty to chart one’s course makes for a gratifying odyssey.

Two closing thoughts:

First, I’m contemplating some content ideas for year three — a podcast (I know, saturated) and / or in-depth interviews with investors, thinkers, writers, etc.

Which of the following interests you most?

  • Podcast exclusively on EM private markets
  • Podcast on EM private markets + other topics
  • Transcripts of interviews exclusively on EM private markets
  • Transcripts of interviews on EM private markets + other topics

Second, I will be in London in October. Please drop me a line if you’d like to grab a coffee.

Alla prossima,
Mike

Advent + Walmart Brazil

Advent International completed its acquisition of 80% of Walmart Brazil, and it’s reportedly planning to invest an additional $485m across its existing stores. As we discussed in February (Always Low Prices), Walmart’s footprint of 471 stores generated revenues of $9.4B in 2016, but delivered seven straight years of operating losses. Why? “[P]oor locations, inefficient operations, labor troubles and uncompetitive prices,” apparently.

Advent purportedly plans to convert Walmart’s hypermarket formats into cash-and-carries, a format that is growing in popularity amongst local consumers. This should help the company improve one of the 5Ps — Price — by extending steeper discounts to customers.

But I’m curious as to how Advent will address another P — Place. Allegedly, Advent does not expect to roll out new stores; how will they address the so-called “poor locations”?

No clue, but it will be one of many interesting stories to watch in Brazil in the months to come.

African PE: Quo vadis?

Earlier this year, EMPEA released a report on The Road Ahead for African Private Equity. It’s quite good and it contains some refreshingly candid observations on the region.

There is a compelling exhibit that hits at one of our biggest frustrations: the concentration of capital in larger segments, and the relative scarcity of capital available for small and mid-size businesses (see below).

EMPEAAfrica

While the chart includes only a handful of countries (and excludes South Africa), I think it’s directionally accurate — the featured countries accounted for roughly half of the investments that took place in Sub-Saharan Africa between 2015-17.

Five additional findings jumped out at me:

  1. Growth equity deals have evaporated, declining by 45% from 2016 to 2017, reaching the lowest total since 2009.
  2. Managers need to bring more than money to the table — operational capabilities are required.
  3. Deal structuring needs to be more flexible and sophisticated. As one endowment representative lamented, “Many GPs are inclined to throw common equity into companies and call it a day.”
  4. Tech-enabled business models are appearing across verticals, creating a richer landscape for VC and PE alike.
  5. Permanent capital vehicles may be a better fit with the investable market than the traditional PE model.

Creador + Goldman Sachs on Asia

Brahmal Vasudevan — founder and CEO of Creador — recently shared some views on PE in Southeast Asia (where performance has been “quite poor”).

Of course, he’s talking his book at a time when Creador is marketing its fourth fund (which it will undoubtedly close at or above target).

Nevertheless, several observations jumped out at me, including:

  • The diversification benefits of regional funds;
  • The merits of maintaining discipline on fund size;
  • The relative scarcity of “high-quality companies that are growing rapidly and need private equity capital” in select markets; and,
  • The potential for adverse selection in control deals.

It’s an interesting contrast with this recent Exchanges at Goldman Sachs discussion about PE in Asia.

Goldman focuses on the “scale and sophistication” of managers, especially in China. But following all the bullishness and capital flooding into the region’s large / megacap funds, I wondered, “who’s the Muppet?”

Like, I don’t have any original insight on this. My rule #1 on China is: nobody knows anything about China — especially me.

But in my passive reading of the headlines from Zhongguo, I’m left with the impression that the winds of change are in the air. Maybe investors have grown complacent.

Mr. China Meets the Mekong

There are few laugh-out-loud books in the world of finance, but Tim Clissold’s Mr. China is one of them. So many instances of an investor being outwitted and outmaneuvered by a crafty operator.

One of the more memorable bits revolves around an acquisition of a Chinese brewery that (naturally) involved a joint venture partner tied to the central government. A few weeks after wiring $60 million to the JV, $58 million appeared to be missing.

Oops.

Missing funds are not at all the issue in this story about a deal-gone-wrong in Vietnam, but as I read the gossip piece, I couldn’t help but laugh.

I mean, it’s not funny … but it is.

Poultry firm Ba Huan JSC has sought the Prime Minister’s intervention in terminating its six-month-old investment partnership with Ho Chi Minh-based asset management firm VinaCapital. The firm said it agreed to investment terms it now claims to be unreasonable because they were initially stipulated in English.

In February, VinaCapital’s flagship fund Vietnam Opportunity Fund (VOF) had invested $32.5 million to acquire a significant minority stake in Ba Huan.

In its petition to the government, the poultry firm noted that VinaCapital is seeking an internal rate of return (IRR) of 22 per cent per year. It claims that the terms of the deal stipulate that in the event of the IRR not being met, Ba Huan will be fined or required to return the investment capital, along with a 22 per cent interest, or it must transfer to VinaCapital (or its partner) at least a 51 per cent stake in the company.

It also alleged that the partnership restricts it from engaging in any other business except chicken and eggs. Its litany of grievances includes what it claims is VinaCapital’s tendency to veto all board decisions, despite it being a minority shareholder.

So many layers.

I don’t know what’s true here … I don’t even have an opinion. I just take the chuckles when they come.

 

A Most Damning Indictment

Several years ago, I was in Marrakech for the UN African Development Forum. As I waited for a car to take me to the airport, a young man in a black suit was lingering nearby, and he was staring at me in a most uncomfortable way.

It got so awkward that I turned to him and asked:

Tatakallam engleezee?

Yes.

Hey man, how’s it going?

I am good, sir. Where are you from?

The United States.

America. I love the United States. I have applied for a fellowship there.

Where?

MIT.

MIT? Are you an engineer?

An economist. I have a master’s degree in applied economics.

Oh. Do you work for the UN here?

No. I am a volunteer. There are no jobs for applied economists in Morocco. Just with the government. I presented my thesis, which [something something labor market, econometrics, etc.]. But they don’t have any jobs. So, I want to go to America to get my PhD and find a job there. It is very nice there.

Have you been?

No.

[Chitchat about Atlanta and T.I. before car rolls up]

Now, as I rode to the airport, I thought about that young man and how frustrating it is to be underemployed — to have knowledge and skills that can be of value to companies and your country, and yet find yourself unwanted. And I thought about the fickle finger of fate that dictates the range of potential life outcomes based on where one’s born and to whom.

I thought about the PE firms pursuing higher education deals in Africa and across the emerging markets. And I thought about all these students (and their parents) paying tuition to get a handhold on the ladder to a better life, and the risk that new graduates might end up like this young man, with a degree that the market doesn’t value.

In development economics, increases in human capital are vital to long-term economic growth. But what happens if the gap between expectations and reality for newly minted college graduates becomes a yawning chasm? I think we know the answer …

Anyway, these musings came to mind recently after I read a most damning indictment of PE investments in for-profit universities. The academic study, When Investor Incentives and Consumer Interests Diverge: Private Equity in Higher Education, explored 88 investments in U.S. for-profit colleges.

What did they find? In summary, following the buyout:

  • Profits↑ by upwards of 3.3x, driven by higher enrollments (↑ 48%) and tuition increases (↑ 17% relative to mean);
  • Graduation rates↓ by 6%;
  • Earnings of graduates↓ by 5.8% relative to a mean across all schools of ~$31k;
  • Per-student debt↑ 12% relative to mean;
  • Educational inputs↓ in absolute number of faculty, with 3% ↓ in share of expenditures devoted to instruction; and,
  • Rent seeking: revenue from public sources (e.g., federal grants and loans) ↑ from 60-70% prior to the transaction to 80%+.

Basically, students end up paying higher prices for inferior products and shittier prospects. Presumably agriculture isn’t a popular field of study, otherwise customers would know where to find the pitchforks.

There are many interesting findings in the paper, such as the nugget that “the returns to for-profit education [for the consumer] are zero or negative relative to community college education.” So, dig in. The online appendix with even more data is available here.

Or, you can look at slides 2, 10-15, and 20 in this presentation to the NY Fed.

From the Bookshelf

In every venture the bold man comes off best, even the wanderer, bound from distant shores.

— Athena in Homer, The Odyssey (Robert Fagles, trans.; Penguin: 1996)

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

 

An Extractive Industry

I remember it like it was yesterday.

30 years ago, my father — God rest his soul — dragged me to the hardware store, with the promise that yet another of my boyhood weekends would be spent “building character.”

But this weekend was different.

Instead of heading home after securing the lumber and dirt, we stopped by a Toys “R” Us.

Dad told me to look around while he spoke with a manager, and when I sauntered back to the front of the store, the manager was retrieving — ever so delicately — a Nintendo Entertainment System from a locked display case. My Dad’s outstretched hands rose to the ceiling, as if offering a prayer, ready to catch the box should the manager tumble from the ladder.

Nintendo. Humankind’s third-greatest invention (after the wheel and the Gutenberg press).

That trip to Toys “R” Us was one of the most joyful moments of my childhood. I am certain that I am not alone — Toys “R” Us was an iconic company that enriched the lives of millions of children.

And private equity destroyed it.

Let’s not mince words: leveraged buyouts (LBOs) constitute an extractive industry.

In the case of Toys “R” Us, Bain Capital, KKR, and Vornado took the company private in a $6.6B LBO in 2005. It is now bankrupt and closing all of its stores — without paying employees any severance.

In the year of the acquisition, the company generated $11.2B in annual sales, and the linked article says their biggest competitors at the time were the discount retailers Wal-Mart and Target. (Amazon’s shares were ~$35, fwiw).

Revenue was never a problem. Net sales never dipped below $11.3B (in fact they exceeded $13B between 2007-13). However, according to SEC filings, Toys “R” Us’s debt burden jumped from $1.86B at acquisition to $5.5B in the fiscal year after the deal, and annual interest expense climbed from $130m in the year of the acquisition to $400m+ beginning in 2006 (see charts). Optimizing capital structures for whom, one might ask.

ToysRUs2

The LBO firms were on the take from the get-go. According to SEC filings, “upon consummation of the Merger, [Toys “R” Us] paid the Sponsors a fee in the aggregate amount of $81 million for services rendered and out-of-pocket expenses.”

In addition, SEC filings show that between 2005-17, Toys “R” Us paid out aggregate “Sponsor management and advisory fees” of $204m. An analysis in The Atlantic suggests there may have been $128m in (incremental?) transaction fees as the company bought up KB Toys (another Bain Capital bankruptcy special) and other toy retailers.

Consider that between 2014-16, when Toys “R” Us was posting losses of $867m, $256m, and $48m, the company paid out advisory fees of $22m, $18m, and $6m. In other words, in the three years that the private equity sponsors were overseeing losses before taxes of nearly $1.2B, they still drew fees of $46m.

That giant sucking sound you hear is LBO firms hoovering out the value from a cash-generating company. One that likely could have remained a going concern, had the LBO firms not forced down such an onerous debt burden.

Again, 30,000 employees were fired without receiving severance. This is Dickensian villainy at its finest. It evokes The Ghost of Tom Joad.

The FT reports that some of KKR’s pension fund clients “are re-examining their relationship with the investment group amid anger over the treatment of workers at the bankrupt retailer.” They should.

But they shouldn’t stop there — they should re-evaluate their investments in LBOs altogether.

Here’s the dirty little secret: when pensions invest in LBO funds, they are fueling inequality.

The entire LBO model is predicated on bogging down cash-generating businesses with debt, and compelling managements’ hands to create efficiency gains (i.e., layoffs). In other words, thousands of people must lose their jobs and benefits, and be plunged into a state of precarity, in order for pensioners to remain secure in their stipends. It is absolutely zero-sum.

One of the most rigorous takedowns of the LBO model is Eileen Applebaum and Rosemary Batt’s Private at Equity Work. I highly recommend it.

Notably, one of their conclusions is that, unlike LBOs, private equity investments in small and midsize companies can drive meaningful business growth and innovation. I — and others — would argue that the opportunities for shared value creation are even greater in emerging and frontier markets.

When I came up with Portico’s ethos, I jotted down the following:

Value creation > value extraction
Build something that increases the general welfare. While there are riches to be made in value extraction, we do not believe in doing well at the expense of others. Spread dignity.

The fate of Toys “R” Us is precisely the type of BS I had in mind when I wrote those lines.

I would encourage all investors to consider the long-term consequences of the LBO model, and to eschew such extractive forms of investment.

Alla prossima,
Mike

P.S. The newsletter is taking a hiatus in August. See you in September.

Raising a Fund

At Portico, we believe in fund managers who are trying to build businesses and increase prosperity across the world.

In a sense, Portico was founded as an anti-gatekeeper. We believe that too many service providers in this industry operate in a black box, and that this lack of transparency ultimately hurts everyone.

With that in mind, we created the Informal Guide to Raising Your First Fund. Our goal with this product is to empower fund managers with the knowledge they need to develop an institutional-quality pitchbook. We’ve bundled it with a 27-page sample pitchbook to maximize its practical utility, and the feedback we’ve received tells us it’s equally relevant for managers raising funds III, IV, and beyond.

Given the exceedingly difficult fundraising environment, we’re pleased to announce that we are now offering it for only $149. It’s more important to us that a greater number of firms succeed — and that the industry develop — than that we sit on useful knowledge.

Invest in yourself. As our next story demonstrates, it’s only going to get tougher for EM managers to raise capital.

Abraaj: Redux

(For background, read parts III, and III)

This is way bigger an exposure than anyone expected … What is shocking is that the company invested almost 10 percent of its total assets and all their investment book with one company.

I am surprised that the company had more than 70 percent of its 1.5 billion-dirham investment portfolio exposed to a single fund and this was never flagged by the auditors or questioned by the shareholders.

These two quotes come from a Bloomberg article on Air Arabia’s disclosure that it faces a $336m exposure to funds managed by Abraaj.

That is a lot of granola. But it’s only part of the story.

Abraaj executed a pre-IPO investment in Air Arabia in 2007, and it secured two board seats in the process. Arif Naqvi retained his position on the board through 2017 (though he didn’t show up to the first three meetings in 2017).

Somehow, nobody seemed to see a conflict of interest in Air Arabia directing “all their investment book” to a board member’s firm?

It gets worse. The Wall Street Journal reports that, “Money originating from Air Arabia was used to replenish the [Abraaj Growth Markets Health Fund], according to people familiar with the situation. KPMG’s review of the fund didn’t mention this, one of those people said.”

KPMG, you may recall, was the firm Abraaj selected to examine the books of its healthcare fund after this whole imbroglio erupted in the press. KPMG is also the auditor of Air Arabia (among other Abraaj portfolio companies).

And then there’s the bombshell.

A separate Wall Street Journal article reveals that PricewaterhouseCoopers, a provisional liquidator for Abraaj Holdings, “have ‘been unable to obtain standalone annual financial statements or management accounts’ for the holding company, a situation they described as ‘highly irregular.’”

Absolutely extraordinary. It’s a sentence worth reading again.

According to the Journal, the PwC report goes on to say:

This lack of financial record-keeping raises the question of how the company’s directors were able to ensure the company was solvent and being effectively managed.

Investment management fees revenue had, for some years, been insufficient to meet its operating costs.

Any liquidity shortfall was largely funded through new borrowings.

Reuters reporting adds that “Abraaj’s total debt stood at $1.07 billion … including $501.4 million in unsecured debt and $572.4 million [in] secured debt.”

The launch of the $6B mega-fund may be viewed in a new light.

The whole situation stinks.

And the stink is on many hands.

Who was doing due diligence? With what documents? Where was the fund administrator?

Institutions were throwing money at Abraaj. Washington State Investment Board, for example, unanimously approved an investment of up to $250m, plus fees and expenses, in the mega-fund, “based on Abraaj’s solid overall investment performance, large, institutionalized team … [and] a consistent investment and risk underwriting process applied globally.”

During the preceding Private Markets Committee meeting, Hamilton Lane “discussed [Abraaj’s] approach to investing, reputation, culture, track record, and currency risk” and supported the staff’s recommendation to invest in the fund.

They’re not the only ones. It’s just that their minutes are public.

Consider, for example, the long list of third parties that provided Abraaj the equivalent of a Good Housekeeping Seal of approval:

  • Abraaj reportedly received its third A+ rating from the UN Principles for Responsible Investment last year.
  • Arif Naqvi was on the Board of the UN Global Compact and a Founding Commissioner of the Business and Sustainable Development Commission
  • He is also a member of “The B Team” — a self-appointed group of business leaders that seeks to advance ESG, etc. Literally the first challenge on their website is, “Drive full transparency: be open, transparent and free from corruption, with good governance and accountability at all levels of our organizations.”
  • The Harvard Business School and Kennedy School connections.
  • The World Economic Forum.
  • Gatekeepers.
  • Auditors.
  • PR firms and the press.
  • Etc.

If there is one lesson from this fiasco, it is that it pays to do your own work.

Also, don’t chase shiny objects.

Fin.

P.S. As we suggested in March, it appears that LPs in the Africa fund are looking for a new GP to manage out the assets.

Small Is Beautiful in CEE

EMPEA recently released a report on private markets in CEE and it’s really quite good. My fundamental takeaway from the report is that the region attracts little capital — between $500m and $1.5B annually between 2009-17 — but this lack of capital is why (a handful of) investors like it.

Consider that, according to the PitchBook data in the study, the median Eastern European buyout multiple between 2006-17 was 5.8x — the lowest multiple globally.

Admittedly, there were few transactions that provided data points for PitchBook, so let’s look at the other end of the spectrum: as of December 2016, EBRD’s portfolio of CEE funds — which is, like, every CEE fund ever — has delivered roughly 7.5% net across all vintages. It’s not an exceptional number, but private equity’s not about investing in an index.

Moreover, it’s not like pension funds — which aren’t pursuing EBRD’s development mandate — are doing much better. According to the American Investment Council’s 2018 Public Pension Study, the median U.S. pension fund’s private equity portfolio delivered a 10-year annualized net return of 8.6%.

Anyway, as I read the briefing, I reflected upon Portico’s thought piece from last December — Does EM PE Scale? — and decided that what’s happening in CEE is a beautiful outcome. The GPs and LPs interviewed for EMPEA’s piece seemed happy with the status quo: most investors have mistaken perceptions of the region’s risks, so they don’t invest in it; and those LPs that do invest in the region have found manager relationships they value across cycles.

Maybe EM PE is an artisanal industry.

Insomnolent in India

Bain & Co. released the 2018 edition of their India Private Equity Report. Lots of charts. Lots of things moving up and to the right.

Bain asked respondents to its survey, “What keeps you awake at night?”

The top three responses:

  • Mismatch in valuation expectations (~75% of respondents)
  • Challenges to maintain high level of returns (~55% of respondents)
  • Lack of attractive deal opportunities (~50% of respondents)

Those seem like … the core elements of running a PE business? No wonder so many Indian GPs are happy to take my calls at 2am IST — they’re not sleeping!

Funnily enough, respondents were least concerned about, “Approaching end of fund life with unliquidated assets” (~3% of respondents).

Now, Bain’s survey had 39 respondents out of a universe of active investors they estimate at 491. But I wonder, would the percentage be much different if the sample size quadrupled?

Zombie4

Turkey: Value Trap?

Last November, we asked if Turkven’s Seymur Tari was precipitating a market turn in Turkey. After seven years of declining business and consumer confidence, was the country on the cusp of a resurgence?

Well. After the latest round of elections, the president’s appointment of his son-in-law as the head of the country’s treasury and finance ministry, and changes to the rules for appointing the central bank governor, one wonders if all those assets trading at a discount might constitute a value trap.

The IMF forecasts gross external financing requirements of ~25% of GDP (equal to ~$200B) each year through 2023.

Turkey’s policymakers confront a delicate dance, indeed.

From the Bookshelf

There is a crime here that goes beyond denunciation. There is a sorrow here that weeping cannot symbolize. There is a failure here that topples all our success. The fertile earth, the straight tree rows, the sturdy trunks, and the ripe fruit. And children dying of pellagra must die because a profit cannot be taken from an orange. And coroners must fill in the certificate — died of malnutrition — because the food must rot, must be forced to rot.

The people come with nets to fish for potatoes in the river, and the guards hold them back; they come in rattling cars to get the dumped oranges, but the kerosene is sprayed. And they stand still and watch the potatoes float by, listen to the screaming pigs being killed in a ditch and covered with quick-lime, watch the mountains of oranges slop down to a putrefying ooze; and in the eyes of the people there is the failure; and in the eyes of the hungry there is a growing wrath. In the souls of the people the grapes of wrath are filling and growing heavy, growing heavy for the vintage.

— John Steinbeck, The Grapes of Wrath (Bantam Books: 1970)

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

 

The Wealth of Nations

A few years ago, my wife and I enjoyed a marvelous walking safari through the bush of Tanzania.

After camping in the village of Nainokanoka, we set off early with Moloton, our Maasai guide, and we trekked amongst the buffalo, gazelles, wildebeest, and zebra on our way to a campsite at Empakaai, a gorgeous crater lake that legions of flamingos call home.

It was positively Edenic … I still can’t believe my wife did it while pregnant …

Anyway, as we walked through some of the villages, I noticed an abundance of domesticated animals grazing around the boma — cattle, goats, sheep, chickens.

Since this was a long hike, I had lots of time to get lost in thought. And I kept pondering one question: who’s wealthier, a Maasai elder or your average American?

I’ve finally written down my take on this thought experiment, which you may read at this link.

Having hit publish on the piece a day after closing on a house (and thus taking on a mortgage for the next three decades), I’ve found myself acutely sensitive to the role credit plays in the U.S. economy. This machine runs on debt … future earnings are earmarked for today’s consumption.

There have been numerous articles of late warning about an impending crisis amongst over-leveraged emerging market companies and governments. A strong dollar / dollar shortage, higher borrowing costs and roll risk are genuine challenges, indeed. As Michael Pettis warned, capital structure matters bigly (see this month’s From the Bookshelf).

However, I think the sensitivity of U.S. households to rising rates is underappreciated. Personal consumption expenditures constitute nearly 70% of U.S. GDP. With higher interest expenses and higher prices due to “trade wars” — and with as-yet-unseen meaningful wage inflation — I think many American households are going to be wondering what happened to the purchasing power of their tax cuts. #youvebeenduped

On the other hand, I think many emerging market countries’ households have stronger, more resilient balance sheets. See, for example, our Maasai elder:

Maasai2

According to EMPEA statistics, only $5 billion was raised for EM PE / VC funds ex-Asia last year, and a measly $397 million in Q1 2018.

The scarcity of long-term capital flowing to these markets tells me that few investors see the world this way. And that may suggest we’re on the cusp of one of the most promising moments for wealth creation that EMs have seen in the last decade.

Have a great summer.

Alla prossima,
Mike

Mekong

Vietnam has been one of the hottest markets of late. Understandably so! It’s an alluring country with tremendous energy.

Chris Freund, founder of Mekong Capital, has been working and investing in Vietnam since the U.S. embargo was lifted in 1994. He has written a refreshingly candid piece on the origin and evolution of his firm, and its role in the development of Vietnam’s private sector.

While the article provides lessons that the Mekong team learned across multiple funds — the perils of strategy drift, the challenges of building strong management teams — it’s also a chronicle that can be read as an embodiment of EM PE’s evolution over the last two decades.

Mekong reportedly plans to go to market with Mekong Enterprise Fund IV.

I wish them well.

LP-GP Fit

The majority of times I meet with GPs, they’re eager to start pitching — which is often why we’re meeting in the first place and is an exciting part of my job. But I usually like to ask if I can talk to you about Sapphire first to give an overview of who we are what our investment thesis is.

That way, we can find out early in the conversation if there is alignment between the fund you’re raising and what we’re investing in. If there isn’t alignment, you’ve just been spared making your well thought out pitch only to find out that your fund is out of scope for Sapphire. Additionally, often times a LP will offer critical clues about what they care about which will allow you to tailor your pitch to what that LP cares about.

So when you walk into a meeting with an LP, pause to ask them about their business first, instead of jumping right into your pitch.

Brad Feld of Foundry Group recently circulated an article by Elizabeth Clarkson of Sapphire Ventures on the issue of LP-GP fit. While it’s focused on the top questions U.S. venture firms should ask prospective LPs, the nine questions are germane to managers of all types of vehicles, in all types of geographies.

I would encourage all GPs to read it.

Know your audience.

The Perils of Business Travel

So there I was — a few hours into a 15-hour flight, staring at the seat-back screen, watching as the icon of our plane crawled northwest on the map, one interminable pixel at a time. Each pixel representing some untold number of miles further from my family.

Locked in that aluminum can, arcing toward Asia at 35,000 feet, in a most calm and reasonable manner, I said to myself, “F@&! this s@&! man! F@&! it!”

It was then that I decided I was going to take a break from air travel, and I have just about reached the end of my self-imposed one-year flight ban.

It has been as great as I thought it would be.

Alas, as I began gearing up mentally to hit the skies again, I came across an article in HBR — “Just How Bad Is Business Travel for Your Health? Here’s the Data.”

The conclusions are pretty jarring:

  • Compared to those who spent one to six nights a month away from home for business travel, those who spent 14 or more nights away from home per month had significantly higher body mass index scores and were significantly more likely to report the following: poor self-rated health; clinical symptoms of anxiety, depression and alcohol dependence; no physical activity or exercise; smoking; and trouble sleeping.
  • A study of health insurance claims among World Bank staff and consultants found that travelers had significantly higher claims than their non-traveling peers for all conditions considered, including chronic diseases such as asthma and back disorders. The highest increase in health-related claims was for the stress-related disorders.

Maybe I should extend the ban …

Sharing Is Caring

Nearly two months have gone by, and I’m still thinking about the ODESZA concert I attended.

Their music won’t resonate with everyone, but if you’ve got a soul and enjoy funky beats, it’s pretty dope. Their jams easily boost my productivity by 33%.

ODESZA’s hitting Singapore, Jakarta, and KL in July, and the show is so good that — all protestations about air travel notwithstanding — I’m tempted to make the trip.

My only reservation is that it just takes so long to get there.

And by that I mean from Soekarno-Hatta to the venue.

There’s a 16-minute teaser of one of their earlier albums, but it’s just the tip of the iceberg. Bon appetit.

From the Bookshelf

Although there are significant differences from country to country and from region to region, from a corporate finance point of view these markets actually have far more in common than they have in differences, and they respond in very similar ways to external shocks …
 
An examination of sovereign debt history suggests that there is no obvious conclusion to be drawn about the correlation between, on the one hand, liberal economic policies and sustainable economic growth, and, on the other hand, industrial policies and economic stagnation. During periods of ample global liquidity, most economic policies seem to ‘work’ because of foreign capital inflows, while they all ‘fail’ when liquidity dries up …
 
The once-conventional and still dominant explanation of capital flows focuses on what are called ‘pull’ factors. This approach … argues that rich-country investors continuously evaluate profit opportunities at home and abroad and, when growth prospects in less developed countries seem favorable, they make the decision to invest … The focus of analysis is on local economic fundamentals, and the basic assumption is that improved growth prospects precede and cause investment inflows 
 
The alternative approach … focuses less on local economic conditions and more on changes in the liquidity of rich-country markets. It posits that when investors have excess liquidity — more than can be invested in traditional low-risk markets at home — they look elsewhere for investment opportunities … Here the basic assumption is that capital inflows precede and cause growth

Because the lure of capital inflows is so powerful, it creates a huge incentive for local policy-makers to implement whatever development policies are currently fashionable among rich-country bankers.

I want to stress the word ‘fashionable’ because there is little historical evidence that previous policy packages that were praised and rewarded by investors were, in the end, successful in generating sustainable wealth.

— Michael Pettis, The Volatility Machine (Oxford University Press: 2001)

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

 

Questions of Leadership

“There is no global EM champion.”

IFC and EMPEA’s Global Private Equity Conference came and went in a blur, but that comment from Nicolas Rohatyn has remained lodged in my brain. There are many ways to read it.

One is to ask: qué? There are global champions that do well in EM. Warburg Pincus comes to mind.

Equally, there are well-known champions within specific markets. A sampling from the BRICs: Pátria in Brazil; Baring Vostok in Russia; Multiples and True North in India; CDH and Hony Capital in China.

Some are less well-known. Some are in other markets. Some are up-and-coming.

Another is to ask if the issue is the lack of a thought leader, like Jim O’Neill (“Mr. BRIC”), who can articulate a fresh vision for the attractions of emerging markets en masse. I’m a fan of Morgan Stanley’s Ruchir Sharma, though he’s a realist not an evangelist. (Maybe that’s why I like him).

Another is to ask if there can ever be a proper EM champion. Can one firm or individual credibly champion all markets at the same time? I think so, but it’s a tough task. Markets across Africa, Asia, Eastern Europe, and Latin America are often at different points in the cycle, with idiosyncratic risks that defy generalization.

Rohatyn’s comment came during a panel titled Global Private Equity Leaders on the State of the Industry. The panelists included a few traditional PE funds (Africa, India, global), but also an energy investor, an Asia credit specialist, and Rohatyn’s firm, an EM hedge fund that acquired a global PE firm (CVCI), as well as EM-focused infrastructure and real estate platforms.

If it’s an uphill battle selling the complexity of EM as a geography meriting investment, is it more so when a discussion with “private equity” leaders includes multiple asset classes?

In any event, if EM private markets are confronting a leadership void — and for all my quibbles it’s a view I share — then who will assume the mantle of leadership?

Alas, questions of — and questionable — leadership were top of mind last week, and they infused the four key themes that I took away from the conference:

  • Crises of Governance
  • Managers not Markets
  • Sustainability Now
  • DFIs and the Mid-Market

Before you jump to the write-ups, this is the last blast before the new General Data Protection Regulation (“GDPR”) goes live.

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Thanks for reading and sharing!

Alla prossima,
Mike

 

Crises of Governance

Piggybacking off of last month’s newsletter, governance — or the lack thereof — was the biggest theme I observed throughout the conference, and this was on display across three levels of analysis: the individual / firm, the state, and the international system.

At the individual / firm level, there were numerous discussions about corporate governance, alignment of interests, and deal / fund terms and structures. However, the most powerful comment came from Jim Yong Kim, who said to David Rubenstein, “The biggest problem is the explosion of aspirations around the world.” Relative deprivation amidst a global political awakening is a potent cocktail for radicalization and unrest.

Ellen Johnson Sirleaf and Mo Ibrahim provided some memorable commentary bridging the firm and state levels. Madame Sirleaf implored, “It is the responsibility of shareholders to use their boards to ensure transparency and accountability, and improve corporate governance.” Ibrahim quipped, “It’s really hard to improve public governance without improving corporate governance.”

At the international level, Ambassador Chas Freeman gave a rundown of the reasons why “risks are reallocating themselves for reasons that are structural,” and set the stage for numerous discussions about political risk.

Ambassador Freeman also introduced troglonomics to the lexicon — “knuckle-dragging mercantilism that emphasizes bilateral trade balances above all else.” It is a delightful, if depressing, addition for our times.

Freeman’s overarching thesis that “international law no longer protects the weak” evokes Thucydides — not only the Melian Dialogue (“the strong do what they can and the weak suffer what they must”), but also the “terrible chapter” on Corcyra’s civil war (see this month’s From the Bookshelf selection).

It’s hard to be constructive, and I’m generally dour on the world’s prospects in the near term. However, I am cautiously optimistic that we are on the cusp of a generational transition — from a culture of fear and anger at losing what was, to one with the confidence and energy to build what can be (h/t Sir Kenneth Clark).

Hopefully this translates to a revivification of a rules-based, harmonious international system.

🤞

Managers not Markets

In years past, much buzz would be made about the market du jour. Panels were populated with prospective private equity kingpins, and the audience would be serenaded with those sonorous words: structural drivers, rising middle class, boots on the ground.

There was an energy and excitement about the prospects of [pick your market]. Never mind that this frequently happened just as the market was topping. It was fun. Remember Mongolia?

Yes, there were regional panels this year (and even one on blockchain), but that invigorating splash of euphoria gave way to more measured discussions around the evolution of the industry (from private equity to private markets), the need for new metrics (on impact), and more practical issues of managing funds and investments.

All of this may be an indicator of a more institutionalized asset class; but it seems to me a subtle endorsement of the idea that it’s managers that make money for investors, not market timing.

One wonders whether it was ever sensible to hype up specific markets, particularly when there are managers that consistently do well in out-of-favor geographies. I’m reminded of a recent interview with the famed short-seller Jim Chanos:

Barry Ritholtz: The last time you and I sat down for a conversation, about three years ago, you mentioned that back in the day there were a few hundred hedge funds, and out of those, 20 or 30 were reliable alpha generators. Today, there’s 11,000 or so hedge funds …

Chanos: And probably 20 or 30 reliable alpha generators.

Sustainability Now

There has been a palpable shift in investor sentiment toward the importance of sustainable investing. The Sustainable Development Goals (“SDGs”) permeated many speakers’ comments, and there seems to be an effort afoot to segment “impact investing” from mainline PE, with the latter being viewed as key partners for attaining the SDGs.

Most allocators are not keen to sacrifice financial returns for “impact” — define the term as you will — but they are looking for managers that deliver responsible, sustainable alpha.

The irony is that some of these managers may very well be “impact investors!”

Nevertheless, the SDGs seem to offer the biggest tent for the array of investors seeking to do well while doing good, and it is manifestly the direction in which large institutional capital is heading.

DFIs and the Mid-Market

Trillions of dollars of private capital will be needed to meet the SDGs. IFC’s CEO, Philippe Le Houérou, spoke about the organization’s new strategy for mobilizing private capital, which includes working with governments to unlock investable projects, and de-risking investments for private capital.

Presumably this was the rationale behind the “DFI Leaders Panel: Moving from Billions to Trillions” — a chance to proselytize about the benefits of investing in emerging / frontier markets before a quasi-captive audience of institutional investors.

And yet, about 15 minutes into an abyss of DFI navel-gazing, a delegate from a university endowment turned to me and asked, “What’s a DFI?”

🤣

The DFIs do amazing work. But I do worry that the emphasis on mobilizing large volumes of private capital will exacerbate the financing gap for mid-market funds and businesses.

To wit, there’s scuttlebutt that some DFIs may be spending less energy on fund investments going forward. Who will intermediate capital flows to smaller companies?

We’ll see; but these discussions brought to mind two of the findings from our July 2017 report The Mid-Market Squeeze.

Basically, are DFIs catalyzing private capital into EM PE funds if: (1) their preferred ticket size is in the sweet spot of commercial investors; and, (2) most commercial LPs would not be more likely to commit to a fund < $250m in size if its investors include DFIs?

No sé.

CrowdinginoroutVertical

From the Bookshelf

Certainly it was in Corcyra that there occurred the first examples of the breakdown of law and order. There was the revenge taken in their hour of triumph by those who had in the past been arrogantly oppressed instead of wisely governed; there were the wicked resolutions taken by those who, particularly under the pressure of misfortune, wished to escape from their usual poverty and coveted the property of their neighbours; there were the savage and pitiless actions into which men were carried not so much for the sake of gain as because they were swept away into an internecine struggle by their ungovernable passions. Then, with the ordinary conventions of civilized life thrown into confusion, human nature, always ready to offend even where laws exist, showed itself proudly in its true colours, as something incapable of controlling passion, insubordinate to the idea of justice; the enemy to anything superior to itself; for, if it had not been for the pernicious power of envy, men would not so have exalted vengeance above innocence and profit above justice. Indeed, it is true that in these acts of revenge on others men take it upon themselves to begin the process of repealing those general laws of humanity which are there to give a hope of salvation to all who are in distress, instead of leaving those laws in existence, remembering that there may come a time when they, too, will be in danger and will need their protection.

— Thucydides, History of the Peloponnesian War (Penguin Classics: 1972).

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

Transparency & Governance

I’ve been meditating on transparency and governance rather frequently of late. Not out of a sense of righteousness, mind you, but largely because they are inescapable in my morning reading of the newspaper: Abraaj, Norway (both discussed below), FacebookMartin SorrellSean Hannity, &c.

The only firm conclusion I’ve reached is that quality governance — corporate or otherwise — is the most underappreciated necessity. A world awash in capital is also a world awash in unaccountable bullshit. People just don’t seem keen to ask — let alone field — questions when the money’s rolling in. Plus ça change …

Say what you will about younger generations, but they’re pretty quick to raise the BS flag and ask uncomfortable questions (so much so that it has become a meme, apparently). I was reminded of this recently while giving a guest lecture at UVA’s McIntire School of Commerce. The students were super sharp, and they asked hard-hitting questions … including one that made me ponder some life choices.

In short, they’re awesome. They rekindled my belief that the future is going to be amazing. Hopefully their incessant questioning will continue as they assume positions of leadership, thus contributing to more transparent and accountable governance. On verra bien …

Speaking of the future, Portico’s first product launch is in the works. We’re making it easier than ever for first- (and second-, and third-, &c.) time funds to produce institutional-quality marketing materials, at a price point that delivers enormous value. Stay tuned!

Finally, I’m really looking forward to IFC’s Global Private Equity Conference next month (hosted in association with EMPEA). It’s the 20th anniversary of the event and it should be a good one. I’m excited to reconnect with friends and make new connections. Drop me a line if you’re planning to attend.

If you haven’t registered, you may learn more about the event at this link. Hope to see you there!

Alla prossima,
Mike

GPEC Banner

Abraaj: Fin?

[This is the third — and final — in a series; see Part I and Part Deux]

“What a mess. I’m left wondering if investors in the firm’s funds will seek (a) new GP(s) to manage out the assets.”

So read the conclusion to my take on the drama at Abraaj in last month’s newsletter.

I don’t know whether the investors drove the process, but Houlihan Lokey was brought in to find a solution to the Abraaj Growth Markets Health Fund debacle, and the FT reports that Abraaj subsequently offered to step down as manager of the fund. An interim manager is reportedly in the cards until a permanent replacement / solution is found.

A few thoughts / observations:

  • Key Person Provisions — More senior departures were reported over the last month, including those of Sev Vettivetpillai and Mustafa Abdel-Wadood, both of whom reportedly attempted to resign late last year but were asked to stay. The Wall Street Journal reports that “the firm now has lost half its managing partners and a third of its partners in the past year.” At this point, given the flood of senior departures, it stands to reason that Key Person termination provisions likely have been triggered across several Abraaj funds. If so, then I imagine investors will be looking for (a) new GP(s) to manage out the assets.
  • Sharks Circling — The firm is reportedly considering a sale of its private equity business to raise cash, and reducing headcount by 15% to cut costs. It is also moving forward with its planned listing of the South African FMCG company Libstar.
    Kenyan sources report that the firm is evaluating a sale of its stake in Nairobi Java House, which it acquired from ECP last year. (I talked about the deal here). The same article reports that sales of Avenue Hospital, Brookside Dairies, and Seven Seas Technologies may be under consideration as well. With all these headlines, management teams and fund managers may be sensing an opportune moment to scoop up shares at a discount from a stressed seller.
  • Exit Closed — In recent years, Abraaj had become an active buyer of PE-backed companies, particularly in Africa (e.g., Java House, Libstar, Mouka). Had its $6 billion mega fund come to market, I imagine Abraaj would have become a sought-after exit channel for GPs. In a way, it could have become to EM private markets what the SoftBank Vision Fund is to venture investors: a deus ex machina of liquidity.
  • &c. — Its portfolio company Stanford Marine has reportedly breached covenants and is seeking to restructure $325 million in debt. Reuters reports that it is seeking repayment of $12.4 million in loans to Nigeria’s C&I Leasing. Deloitte has been called in to look into its governance and control issues. &c.

I’m tired of writing about Abraaj. I don’t plan on including anything about the firm in next month’s newsletter.

The news articles are likely to keep coming, though, and the developments over the last month suggest that it will take a long time to clean up the detritus from this unfortunate turn of events. Here’s hoping that it doesn’t contribute to investors’ exodus from EM private markets altogether.

Norway: Part Deux

In January’s newsletter, we mentioned that Norway’s sovereign wealth fund had submitted a recommendation to the finance ministry that it be allowed to invest in and alongside private equity funds. At the time, we held out a grandiose vision of a world in which the fund might build a genuinely differentiated approach to EM private markets.

Well, the finance ministry has issued its report, and fund managers’ hopes for a veritable tsunami of cash have been put on hold.

Indefinitely.

The preliminary, unofficial translation of the report provided a fairly damning assessment of the asset class’s fees and opacity:

Low costs are characteristic of the GPFG. External equity management costs in the listed market are about 0.5 percent … measured relative to assets under management. In comparison, the annual cost of investing in private equity funds can be estimated at about 6 percent of assets under management …

Transparency is an important prerequisite for broad support for, and confidence in, the management of the GPFG. Many private equity funds disclose little information about their activities …

High prospective returns aren’t a sufficient argument for new money to come into the asset class — especially when its citizens’ savings. We’ve said it before and we’ll say it again: the industry will not thrive without trust, transparency, and quality corporate governance.

Bain & Co.

Two findings jumped out at me from Bain & Co.’s Global Private Equity Report 2018:

  1. Entry pricing is … inauspicious.As of year-end 2016, the percentage of deals priced at <7x EBITDA (~10%) was the lowest it had been since at least 2007, while 54% of deals were done for >11x EBITDA (compared to ~35% in 2007). “Our presumption is that we’ll be exiting at smaller multiples,” says Alan Jones of Morgan Stanley Global Private Equity. Agree
  2. Long-hold funds can outperform. Bain ran an analysis comparing a theoretical long-hold fund selling an investment after 24 years against a buyout fund selling four successive companies over the same period. Their finding: “By eliminating transaction fees, deferring capital gains taxation and keeping capital fully invested, the long-hold fund outperforms the short-duration fund by almost two times on an after-tax basis.” [emphasis added]

At Portico, we’re privileged to work with firms that are pursuing non-traditional and longer hold strategies. We think it’s only a matter of time before more investors come to see the benefits of these approaches.

Grab Bag

  • Into Africa—The FT reports that the EBRD is considering an expansion into Sub-Saharan Africa. The politics of getting this approved might be tricky, but EBRD could do a lot of good on the continent. 🤞
  • India — IFC’s Ralph Keitel gives a masterclass on PE in India in this interview.
  • Management Fees— Dave Richards of Capria has an interesting view on how GPs should be determining their management fees. Hint: they should be predictable and budgeted, rather than a percentage of committed / invested capital.
  • Theranos— “It has been pretty obvious for a few years now that Theranos Inc. was a huge fraud.” Matt Levine’s take on the Blood Unicorn, Elasmotherium haimatos. And, its solicitation for cash after its CEO settled fraud charges?

From the Bookshelf

Make friends with those who are good and true, not those who are bad and false.

— Eknath Easwaran (trans.), The Dhammapada (Nilgiri Press: 2007).

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

The White Stripe

A small print of Jody Clark’s “Keep Treading” hangs on a wall in my office. It’s a picture that I first saw at the Brazilian Jiu Jitsu (“BJJ”) gym where I started training last fall. It shows a man in a gi trying to stay afloat in the ocean. An eel is wrapping around his legs and pulling him asunder, while a collection of sea nettles threatens to sting him if he reaches out his arms.

It’s an apt metaphor for the travails of a white belt in BJJ. As Sam Harris describes it, “The experience … is akin to falling into deep water without knowing how to swim. You will make a furious effort to stay afloat—and you will fail.”

That is an accurate one-word summation of my first five months in BJJ: failure. Relentless, unmitigated failure. Soul- and ego-crushing failure.

Consider this dispatch from my BJJ journal:

2/10 – Open Mat

Performed poorly. Got smashed. Decent defense but too passive. Need to be more aggressive. Neck got crushed while in turtle. Honestly I just feel dejected.

There are days when the hardest thing is showing up to class or open mat. The certainty of being smashed, submitted, and in pain makes it all seem like a futile exercise. It’s so tempting to quit in the face of near-certain failure.

But, you have to keep treading. It’s all a bit of a metaphor for life as a whole.

Last week, I received my first stripe on my white belt. I know it’s foolish to place much stock in outward signs of progress, but this promotion—this piece of tape—was one of the more hard-earned accomplishments in my life. And yet, it’s merely the first rung on the ladder. Progress. One aching, small step at a time.

In other news, I’m looking forward to joining some folks from General Atlantic next month for a conversation with students at UVA’s McIntire School of Commerce. Should be fun!

I’ve also created a video of the presentation that I delivered at the UNC Alternative Investments Conference last week (some of the slides are featured below). If you’re keen to see a 30-minute overview of EM PE, check it out on YouTube!

Alla prossima,
Mike

Abraaj: Part Deux

In last month’s newsletter we discussed the drama at Abraaj following revelations that four LPs had hired forensic accountants to probe the books of the Abraaj Growth Markets Health Fund.

The situation is serious, indeed:

  • Abraaj’s fund management business is being split off into a separate entity with an independent board “to which internal audit and compliance will directly report.”
  • Abraaj’s founder, Arif Naqvi, relinquished management of the funds business, though he is expected to serve on its investment committee.
  • The firm announced a halt to investment activities.
  • Private Equity News reports that Themis, the energy team that Abraaj acquired in March 2016, sought to end its partnership with the firm as early as mid-2017. Denham Capital announced a new platform agreement with Themis earlier this month.
  • The WSJ reports that the firm is weighing job cuts as its fundraising is put on hold; existing investors in its $6B target mega fund are asking for their money back; investors in other funds are considering selling their stakes; and, lenders are reviewing credit lines for their capital call facilities.
  • The FT reports that the firm’s CFO departed.

Meanwhile, the firm is still unable to secure an exit from K-Electric, a divestiture it announced in October 2016. Abraaj was slated to receive a consideration of $1.77B from Shanghai Electric Power, a subsidiary of the State Power Investment Corporation of China; however, the transaction has been dogged by delays.

According to a local news report dated 9 March, the Pakistani government still had not cleared the sale, in part because it has not received a copy of the sale-purchase agreement, in part on national security grounds, and in part because the company is alleged to owe “dues” upwards of PKR139 billion (~$1.25B). Arif Naqvi is reported to have met with government ministers this week in an attempt to accelerate the sale.

What a mess. I’m left wondering if investors in the firm’s funds will seek (a) new GP(s) to manage out the assets.

EM Fundraising: Coming Full Circle?

 

giphy2

“Coming Full Circle.” So reads the adulatory headline from EMPEA’s year-end 2017 statistics, which show $61 billion in EM fundraising across PE, private credit, and infrastructure and real assets—the highest level since 2008. Break out the champagne glasses and lace up those dancing shoes. EM PE is back!

Or not.

Looking at fundraising for buyout and growth equity funds, the volumes remain stagnant since 2011 (see below). Though 2017 shows a rebound, the aggregate figure is deceptive: KKR Asia III clocked in at $9.3B and Affinity Asia closed on $6B, which means these two funds account for 40% of the capital raised for buyout and growth strategies. That leaves about $20B for the rest of EM. It’s peanuts!

FRchartv2

The trends we highlighted in November 2016 are continuing apace, with only 75 growth equity funds achieving a close in 2017—a 44% decline since 2010. In addition, new entrants are struggling to get traction. EMPEA’s own analyses show that first-time growth equity funds have declined from 30% of the capital raised for the strategy in 2008-09 to less than 10% over the last four years.

At issue is a lack of distributions and a lost decade for LPs in EM buyout and growth equity funds (see below). There is a sharp drop-off in distributions beginning in 2007 / 08 when fundraising exploded. It’s a decade later, and the breakpoint for top-quartile funds beginning in 2008 hasn’t returned investors’ capital.

lostdecade

These performance indicators from Cambridge Associates are damning, and it’s no surprise why LPs have been walking away from “traditional” EM PE in greater numbers.

But there’s something about this exhibit that bothers me. I know many established managers that refuse to provide their performance figures to Cambridge. One global manager was befuddled when I presented these figures; s/he noted that their EM deals generated IRRs well north of 30%.

It’s worth asking whether Cambridge’s benchmarks are a worthy benchmark in EM. I have my doubts.

For example, a quick sketch comparing the universe of EM buyout and growth equity funds—as collected by EMPEA—to those in Cambridge Associates’ database show that CA has between 4% and 21% of the total number of funds by count, and between 29% and 60% by total capitalization (excluding 2011; see below).

cambridge

The industry is poorly served by these benchmarks. I should probably stop using them, but there is no credible alternative.

If only there were an organization that could serve as a utility for the industry—one that provided impartial data on private capital performance … 🤔

In any event, as bearish as I’ve been about the prospects for the EM PE industry, I am cautiously optimistic that we’re close to reaching a bottom. If flows to EM public equities continue, then the exit windows should stay open, managers should distribute cash to their LPs, and then capital can be recycled to new commitments.

While I don’t expect EM-dedicated growth equity and buyout funds to come “full circle” to the $58 billion they raised in 2007 anytime soon, the scarcity of capital allocated to the sub-$1 billion segment portends well for the performance of current vintages. And if history is any guide, LPs will herd back into these markets after the “easy” money has been made.

giphy1

Private Equity: Overvalued and Overrated?

Dan Rasmussen of Verdad is not making friends with many people in private equity. His former colleagues at Bain Capital must wish he’d stop talking. Like him or hate him, Dan puts out thought-provoking, empirically driven takes on the myths and realities of U.S. buyouts (see last December’s newsletter for an example).

In his latest piece, “Private Equity Overvalued and Overrated?”, Dan probes three premises about which there is “near-complete consensus:”

  • PE firms make money by creating value in portfolio companies;
  • PE is less volatile / risky than public equity; and,
  • PE will significantly outperform other investments.

Rasmussen’s most interesting conclusion pertains to the first bullet: the myth of value creation. Verdad constructed a database of 390 deals—representing more than $700 billion in enterprise value—for which the PE firm issued debt to finance the acquisition. This enabled Verdad to compare underlying companies’ financial performance both pre- and post-acquisition. What did they find?

In 54 percent of the transactions we examined, revenue growth slowed. In 45 percent, margins contracted. And in 55 percent, capex spending as a percentage of sales declined. Most private equity firms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth.

If PE firms are not growing businesses faster, investing more in growth, or gaining much operational efficiency, just what are they doing?

In 70 percent of cases, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet, from 2.5x EBITDA to 5x EBITDA—the biggest financial change apparent from our study.

With $1.7 trillion in dry powder, rising rates, and average U.S. LBO entry multiples hitting 11.2x EBITDA, this just does not seem like an attractive value proposition.

Persistence in Private Equity

McKinsey’s Global Private Markets Review has a fascinating finding on the decline of persistence in private equity performance. Notably, “follow-on performance is converging towards the 25 percent mark—that is, random distribution.”

At a time when capital is flooding to mega-cap funds and, at least in emerging markets, established GPs with a track record, I wonder whether new techniques are needed for manager selection. Perhaps the winning LPs will be those with the liberty to chase a variant perception of value; those less hamstrung by rigid asset allocation buckets and / or institutional constraints.

Je ne sais pas.

From the Bookshelf

A man is born gentle and weak.
At his death he is hard and stiff.
Green plants are tender and filled with sap.
At their death they are withered and dry.

Therefore the stiff and unbending is the disciple of death.
The gentle and yielding is the disciple of life.

Thus an army without flexibility never wins a battle.
A tree that is unbending is easily broken.

The hard and strong will fall.
The soft and weak will overcome.

— Lao Tsu, Tao Te Ching (Vintage: 1989).

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.