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.