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.

 

Does EM PE Scale?

Does the emerging markets private equity asset class scale?

No. I don’t believe it does.

In fact, I think the absorptive capacity of EM PE / VC is as low as $16 billion in new flows per year, compared to the $40 billion in fundraising we’ve seen on average since 2011. At least, that’s my finding in Portico’s most recent research piece: Does the Emerging Markets Private Equity Asset Class Scale?

The inspiration for this think piece comes from Fred Wilson, co-founder of Union Square Ventures, who wrote a fascinating blog post in 2009 on “The Venture Capital Math Problem.” If you haven’t read it, you should. In it, Fred concluded that the volume of exits in U.S. venture right-sized the industry between $15 billion and $17 billion in flows per year, remarkably similar to the conclusion I reached.

While this piece isn’t likely to win me many friends, I hope that it provides some food for thought, and that it sparks some lively conversations. I’d love to hear your feedback!

A humble request. We’re trying to grow our (monthly-ish) newsletter’s audience in 2018. If you enjoy this newsletter and / or know someone who would, then please feel free to share it with them. It’s free to sign up for future issues at www.tinyurl.com/porticonewsletter, while previous editions are available here.

For each new (human) subscriber we get between now and 30 December, we’ll make a donation to Room to Read, a nonprofit active in Africa and Asia that focuses on literacy and gender equality in education.

Happy holidays to you and yours, and best wishes for health and happiness in 2018.

Alla prossima,
Mike

Mea Culpa

A mea culpa is in order. In last month’s newsletter, I (somewhat cheekily) called out IFC for committing $25M to Carlyle’s $5B Asia Partners V; it was actually to their ($1B target) Asia *Growth* Partners V. Sloppy mistake. I apologize. Thank you to the discerning reader who noticed my error and called me out on it.

That said, I still don’t understand why IFC is funding a fifth-series Carlyle fund. According to IFC’s disclosure of the commitment, as of 31 December 2016, Carlyle held approximately $158B in AUM. This figure is ~70% greater than IFC’s total assets, ~4x the value of IFC’s total investments, and nearly 12x the value of IFC’s equity investments (as of 30 June 2017; see IFC’s consolidated balance sheets at this link).

¯\_(ツ)_/¯

KKR Quits Africa

We’ve dedicated a decent number of pixels in our newsletters to the issue of large-cap deal flow in Africa. Late last month, KKR decided to disband its Africa team for good. Several of the team’s dealmakers left earlier this year, in part, it seems, because they were investing out of KKR’s European fund and were losing out to French, German, etc. deals in IC meetings.

But a KKR spokesman breaks it down pretty plainly: “To invest our funds we need deal-flow of a certain size. It was especially the deal-size that wasn’t coming through.”

Invariably, KKR’s spokesman continues, “There was enough deal-flow at a smaller level.”

The Power of Compounding

Albright Capital recently released an enjoyable piece on “The Power of Compounding” in an EM portfolio. The firm compares the returns that three hypothetical long-only investors would have received from the MSCI EM, based on their (in)ability to time the market.

It’s an original thought experiment with results that might surprise you.

Will Robots Disrupt Private Equity?

McKinsey Global Institute released its analysis of the impact of automation on jobs. They estimate that “up to 375 million people may need to switch occupational categories” by 2030, with up to one-third of the U.S. and German workforces—and half of Japan’s—needing to learn new skills and pursue new occupations.

Will “private equity investor” be one of these disrupted occupations? Could robots do a better job at allocating capital? Given the recent performance figures, at least in EM, one could be forgiven for thinking so.

There’s an alluring argument that private markets are less ripe for disruption than public markets: not only is there less data available, but also the manager can apply sophisticated judgment and hard-earned pattern recognition skills to source proprietary deals, construct a quality portfolio, and create value.

I’m not entirely convinced. Consider an analysis from Dan Rasmussen of Verdad, who, whilst at Bain Capital, examined 2,500 deals representing $350 billion of invested capital:

About one-third of the deals analyzed accounted for more than 100% of profits (no surprise there) and the majority of the deals in the sample fell well short of the forecasts built into the financial models. The biggest predictor of whether a company would be a big winner or not was the purchase price paid. The dividing line seemed to be 7x earnings before interest, taxes, depreciation and amortization (EBITDA). When PE firms paid more than 7x EBITDA, their chance of success plummeted — regardless of how much managerial magic they threw at it. The 25% of the cheapest deals accounted for 60% of the profits. The most expensive 50% of deals accounted for only about 10% of profits.

In other words, all the fancy analysis and financial models performed worse than the simple rule “buy all deals at less than 7x EBITDA” [emphasis added]. A simple quantitative rule worked better than expert judgment.

I was recently speaking with Abby Phenix—formerly of Advent International, now assisting PE firms with customer due diligence—and we ended up riffing on this topic for a bit. In the past, she raised some thought-provoking points about the automation prospects for manager selection (think funds of funds) and investment analysis (think associates), which could enhance productivity and reduce costs (think management fees).

What is it that investors want? Cost-effective exposure to the investable asset or the privilege of paying fees to the middleman?

Is it Possible to Short Graduate Schools?

This statistic surprised me: the stock of U.S. student loan debt ($1.3 trillion) is now equal to the size of the U.S. junk bond market. Astonishing.

Estimates from The New America Foundation suggest that upwards of 40% of this is tied to graduate school debt. If I could short the graduate education market directly, I would.

Consider that in 2012, 25% of graduate students were burdened with at least $100,000 of student loan debt. Meanwhile, in 2016, the median incomes for master’s degree holders in the United States were roughly $80,000 for males and $58,000 for females. The math doesn’t work, prospective students know it, and there’s a broad-based slowdown in applications (see below).

ex71

Effectively, the market for graduate education experienced a debt-financed positive demand shock, universities expanded supply, and now there is a negative demand shock. Schools will need to cut tuition and take a hard look at which costs can be cut.

If you’re keen to learn more about just how much of a mess this is, I wrote a piece about this on my personal blog (source of the exhibit above).

Lots of data. Lots of charts. Oodles of other content.

From the Bookshelf

I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.
(Ecclesiastes 9:11)

For what is a man profited, if he shall gain the whole world, and lose his own soul?
(Matthew 16: 26)

The Bible: Authorized King James Version (Oxford World’s Classics: 2008).

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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 2017, all rights reserved.