Expectations v. Reality

One thing that never ceases to entertain me is when an institutional investor says s/he expects 3x from an emerging market private equity fund.

“We want to be compensated for the risk we’re taking.”

Makes sense.

But how is that risk measured? People don’t seem to be using a Sharpe ratio, or some such analytic that disaggregates measures of alpha per quantum of risk.

According to Aswath Damodaran, the equity risk premia between developed and emerging markets have converged since the turn of the millennium. One could argue that investors should accordingly expect a lower premium from EM PE over time.

Using the spread between U.S. Treasurys and local sovereigns for a risk premium seems lazy. Private EM companies can be better credits than the countries where they operate, and actually have a lower risk profile than publicly listed companies (e.g., mining, oil & gas).

Also, it’s 2019.

Are we going to act as if many of these countries don’t have banks, and insurance companies, and mobile network operators now? There is a lot more competition, and a lot more capital scouring the landscape for deals (much of which is neither institutional nor residing with asset managers seeking PE-like returns).

Yet these markets are dynamic, and exciting, and they present an opportunity for investors to build great businesses. It’s not like the pass-the-parcel, value-transfer game in developed markets.

To be clear, there absolutely will be EM deals and perhaps some funds that deliver ≥ 3x net DPI at the end of their life. But if you’re an institutional investor investing in institutional-quality funds, what are the odds that you’re going to pick one of these winners?

Low. In all likelihood, you’re probably going to wait until the firm has a track record and built up its back office to satisfy your trustees.

By then, said firm will have scaled and begun investing in larger companies, and the economies and sectors in which they’re investing will have evolved materially.

All of these behaviors are reasonable. But the idée fixe of getting 3x is not.

If you’re going to wait for managers and markets to institutionalize and de-risk, then you should be willing to give up some of the upside. You don’t deserve it.

How realistic is the expectation of 3x, anyway?

Take a look at CalPERS’ experience (see below). Of the 268 PE funds in its portfolio (excluding vintage years 2016-18), only two funds clear the 3x hurdle.

Screen Shot 2019-02-11 at 8.29.04 AM

Only 36 funds (~13%) have delivered at least 2x. Meanwhile, 80% of the funds sit between 1x and 2x, and nearly half are valued at less than 1.5x.

And lest we forget, these are with PE firms’ marks …

We could tie ourselves in knots in a discussion over the suitability of CalPERS’ portfolio as a data set, but a bogey of 3x in EM just seems unreasonable.

New rule: stop being unreasonable.

Alla prossima,
Mike

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Liquidity

Investors often talk about the need for private equity firms to harvest an illiquidity premium — an incremental return above that generated in public markets.

The idea makes sense …

… when public markets are liquid.

But what happens when an exchange can’t absorb trading volumes? What if it fails in its job of serving as a market maker?

You should probably ask the people who tried to sell shares of Jardine Matheson Holdings Ltd. — one of the largest listed companies on the Singapore Exchange — at the market’s open on January 24th.

Says Bloomberg:

Shares sank just before the regular session began, with about 167,500 changing hands at just $10.99, compared with Wednesday’s close of $66.47. Jardine, the flagship investment firm of a 186-year-old conglomerate, soon recovered from the $41 billion wipeout and ended up closing 0.5 percent higher.

Selling at an 83% discount seems … not to be a great advertisement for the benefits of liquidity.

CMC Markets Singapore analyst Margaret Yang Yan is a bit more candid:

This kind of stupid mistake shouldn’t have happened in an established stock exchange. It is the largest exchange in south-east Asia … It’s ridiculous.

Also ridiculous: not putting in a limit order?

This markdown never would have happened if Jardine Matheson were a PE portfolio company. But then …

———

Sell!

The trickle of exits / distributions from EM PE funds is a fact of life. We often hear about structural reasons for this logjam — the depth of local capital markets, for example.

But, what if it has little do with EM, and more to do with dealmakers’ biases? What if (most) everyone’s actually good investing?

In “Selling Fast and Buying Slow: Heuristics and Trading Performance of Institutional Investors,” a group of researchers analyzed 783 institutional portfolios with an average portfolio value of ~$573m. The dataset included 4.4 million trades between 2000-16.

Say the authors:

We document a striking pattern: while the investors display clear skill in buying, their selling decisions underperform substantially. Positions added to the portfolio outperform both the benchmark and a strategy which randomly buys more shares of assets already held in the portfolio … In contrast, selling decisions not only fail to beat a no-skill strategy of selling another randomly chosen asset from the portfolio, they consistently underperform it by substantial amounts. PMs forgo between 50 and 100 basis points over a 1 year horizon relative to this random selling strategy.

Basically, one way to enhance performance is to become a better seller.

Maybe this could be a new skillset to hire for? Someone who sits at the table during portfolio reviews and offers constructive comments, such as, “Maybe we should sell [company].”

Or someone who walks around the office offering a helpful feedback.

Deal Gal: This promoter is a pain in my rear. The board meetings are a shambles. He won’t listen to anything we have to say.

New Guy: Hmmm … [pauses for dramatic effect and adopts hipster podcaster voice] Have you thought about selling it?

Deal Gal: But he knows what he’s doing! If we hold on to this company for another 18 months we could be looking at a 3-bagger.

New Guy:

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Emoji Compliance

In Portico’s first research piece, I noted that the growing costs of compliance were taxing the bandwidth of smaller fund managers, and regulatory complexity was making it more difficult for firms to raise capital.

[You can envision billionaires at mega-cap firms pulling up the drawbridge behind them as regulation stifles competition and entrenches their firms’ market position.]

Well, Kirkland & Ellis sent out an update about some recent Delaware decisions regarding text messages, personal emails, and corporate litigation that brought home how absurd the world has become.

Chancellor [Andre] Bouchard added that he often finds texts to include especially probative information, particularly when covered in emojis. In a recent decision (Transperfect), he attached significance to a smiley-face “emoticon” included in one of the party’s texts as evidence of the malign intent of the sender.

Look, I am out of my depth when it comes to the legal implications of emoticons. But what’s the over / under — in months — before a DDQ contains responses to one of the following questions:

  • What is your policy on emoticon use?
  • Have you disabled controversial emoji across all devices, messaging, and email clients?
  • Have you staffed up your emoji compliance function with digital natives who can discern malignant intent amongst the extant universe of 2,500+ emojis?

———

Blackstone Quits Africa

No surprises here. Secondo Il Sole 24:

Il problema, sembra, è che Blackstone non ha trovato grandi operazioni da finanziare [emphasis added]. E la competizione cinese ha complicato la situazione. Anche KKR incontrò difficoltà simili tanto da smantellare nel 2017 il team di persone dedicate al continente africano e vendere il suo unico asset in quella regione, un produttore etiope di rose.”

QED.

———

Inspecting the Books

Catalyzing private capital is one of the core missions of the development finance institutions. Oftentimes, in EM private markets, this takes the form of seeding local managers and building them into institutional-quality firms (see intro).

But, what if there were another way? One that didn’t take so long. One that evoked the spirit of a place, and its people, and it propelled you to book a ticket to visit that manager in Poland or wherever.

Then you might learn about the 1 million family-run businesses that are in need of succession planning. Or the scarcity of expansion capital in a market of ~ 40 million consumers.

You might put down some Żywiec and pierogi, and get lost in Warsaw.

You might, actually, feel alive.

Manager visits wouldn’t be like those depressing trips where you eat Panda Express in a Holiday Inn Express, and the view out your window is of a half-vacant parking lot and a highway.

The EBRD has released the longlist for its 2019 Literature Prize, and until this moment I didn’t think I wanted another job, but I will read books and tell you which ones I like if you pay me to do so.

It’s a pretty cool looking collection from EBRD’s geographies. Hope you find something you like.

———

From the Bookshelf

For the first time in my life I understood that the sense of poverty is not the result of misery but of the consciousness that one is worse off than others.

Providence is no substitute for prudence.

— Jan Karski, Story of a Secret State (Houghlin Mifflin Co.: 1944)

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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 2019, 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.