The Winner-Take-Most World

Did you know that KKR said it collected $1.4 billion in management fees last year?

And that its annual income from management fees has grown by $710m since 2015?

It blows my mind.

Hats off to the team for executing a bold growth strategy.

But … it just seems like a waste of money, doesn’t it?

The firm collected $6.2B in management fees between 2015-20.

The bulk of that likely flowed to individuals with a low marginal propensity to consume. 

(Comp and benefits accounted for ~70% of expenses between 2018-20, according to the latest 10-K).

And it also flowed to a firm with a low marginal propensity to invest. 

(Based on the historical financials accessed via Koyfin, the firm’s MPI [= ΔI / ΔY] was actually negative comparing 2015 to 2020; it averages out to 0.11 between 2016-20).

What boggles the mind is there are allocators at large institutions who have no compunctions about handing a growing amount of pensioners’ savings over to mega-cap firms, largely to pay the latter’s employees to show up to work.

It’s not as if this is hidden knowledge. It’s laid out in public filings. For instance, here’s KKR’s segmented revenues for 2020:

What an amazing business.
 
(Note that the management fees in the chart are provided on a GAAP basis, and the $1.4B figure cited at the top is based on a KKR presentation featuring recast, non-GAAP financials).

* * *

When I see KKR’s $710m increase in annual management fees, I can’t help but think about several clients that are raising funds and could invest that money in wealth- and health-creating companies. 
 
Alas, these firms aren’t on many LPs’ radar screens because their fund sizes are “sub-scale.” Or they require too much legwork. Or they’re so “risky” that it makes more sense to pay a toll to KKR (and / or Apollo / Blackstone / Carlyle, etc.) than to use it as callable capital.
 
Look. This isn’t just about KKR. They’re a premium brand for a reason.
 
But the specific case is useful for what it tells us about private markets and the world more broadly.
 
And that is that we’re in a winner-take-most economy.
 
The inequalities across multiple vectors have been getting worse for a long time.
 
Just look at this chart from Morgan Stanley global strategist Ruchir Sharma (source):

I believe the consolidation of capital in fewer, large-scale managers is leading to less innovation and more sclerosis. And I think the incentive structures at large LPs and GPs are broken, contributing to poisonous outcomes.

It’s all a bit evocative of Matthew Klein and Michael Pettis’s Trade Wars Are Class Wars, which argues that international trade conflicts are a direct result of domestic inequality. Namely, “a conflict between bankers and owners of financial assets on one side and ordinary households on the other.”

It’s unsustainable.

— Mike


The Caesars Palace Coup

Speaking of mega-cap buyouts, I have a summer book recommendation: The Caesars Palace Coup by Max Frumes and Sujeet Indap.

It’s a riveting telling of the rapacious actions of Apollo and TPG, and the combative restructuring of Caesars Entertainment. 

A taste:

Too many people — and often twenty- and thirty-something-year-old men trying too hard to prove themselves as tough guys — private equity and hedge fund alike, were fighting merely out of vanity. Most of these funds took money from identical pensions — Texas Teachers, CalPERS, CalSTRS. These fights to the death just moved money from different pockets of the same investors.


Mobile Money Metrics

GSMA has released its Mobile Money Metrics portal.
 
Given the vital and growing role that mobile financial services play globally, this is a terrific resource not only to glean insights on the scale of mobile money accounts, agents, and transactions by geography, but also the names of services in each country. 
 
It’s awesome. Check it out.


The Abraaj Fiasco

I wanted to experiment with a different format with the Portico Podcast, and decided to revisit my writings on the Abraaj fraud scandal as they were happening in real time a few years ago.

It’s hard to overstate the impact Abraaj’s governance failures had — and continue to have — on EM private markets. Give it a listen and let me know what you think.


Persistence in PE / VC Performance

fresh look at the persistence of PE & VC funds using Burgiss data.


From the Bookshelf

For decades, the U.S. Treasury’s approach to international finance was driven largely by what made sense for major American commercial and investment banks and the owners of financial capital. The interests of everyone else in the economy were largely ignored, if not outright opposed by counterproductive commitments to maintain a strong dollar. This was always justified on the grounds that deregulating capital and increasing its mobility would lead to the best possible outcomes.
 
The resulting increases in wealth, they explained, would inevitably trickle down to all Americans — never mind that international capital flows are far more likely to be driven by speculation, investment fads, capital flight, and reserve accumulation (often for mercantilist purposes) than by sober investment decisions about the best long-term uses of capital …
 
The world’s rich were able to benefit at the expense of the world’s workers and retirees because the interests of American financiers were complementary to the interests of Chinese and German industrialists. Both complemented the interests of the wealthiest throughout the world, even from the poorest countries. The modern surplus countries do not need colonies to absorb their excess production because they can work with bankers, their willing collaborators in the deficit countries.
 
The perverse result is that deepening globalization and rising inequality have reinforced each other.

— Matthew C. Klein and Michael Pettis, Trade Wars Are Class Wars (Yale University Press: 2020)

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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 2021, all rights reserved.

The Boring Twenties?

How many times in the last three months have you heard someone say, ‘it’s going to be the Roaring Twenties’?

Dozens?

Scores?

Hundreds?

I’ve lost count.

In all my life, I can’t remember a more ubiquitous sentiment.

Perhaps this is one of those phenomena that humanity wills into existence, but I keep wondering: where were you people living during the last decade? Under a rock?

Like, what if the Roaring decade already happened? And you missed it?!

I’m no historian, but I enjoy reading histories. And I’m no expert, but I’m as capable as Ian Bremmer at spouting spurious nonsense.

Consider a few parallels:

  • Mass communication — the Roaring Twenties had the radio and movies; but the 2010s saw communications technology supercharged at a level people in the 1920s could never imagine. I mean, global mobile and smartphone adoption, Twitter, YouTube, the societal parasite that is Facebook, WhatsApp, TikTok, etc. etc. etc. 
     
  • Consumerism — the 2010s were the era of the “emerging consumer.” According to World Bank data, global household expenditures grew by $10.7 trillion (in real terms) between 2010-2019, with China accounting for 25% of that. Choose most any country of sufficient scale, and you will find an e-commerce platform, on-demand media / delivery, etc.
     
  • Corruption and fraud — “We are in the golden age of fraud.” Corruption and fraud are omnipresent, at a scale humanity has never seen.
     
  • Sexual revolution — I wasn’t around in the 1920s, but I have watched Babylon Berlin, and it’s inconceivable that anything back then could compare to the meat market that is Tinder. 
     
  • Stock market — went totally gangbusters!

Don’t get me wrong — I think there will be an explosion of hedonism and euphoria on the back end of the pandemic.

I, myself, daydream of escaping to Beirut to see a Tala Mortada gig … 
dancing / sweating / in a smoke-filled club / with bass so hard / it hurts.

Or trekking to Central Asia and touring the Silk Road to get as far away as possible from my sons (whom I love more than anything … it’s just been way too long without a breather).

But … most of us know what lies in wait in those deserts.

And I’m not referring to the diarrhea.

I mean the nostalgia for home.

think the surprise is that people will crave genuine connection and intimacy after a decade in the Matrix.

Alas, instead of the Roaring Twenties, I wonder if we’re more likely to see the Boring Twenties.

Less flash. Less sizzle. Deeper, more meaningful relationships, work, and — dare I say — innovation.

And I must confess: given the economic, environmental, (geo)political, and social risks brewing and bubbling beneath the surface of our Botoxed world, a bit of boredom would be positively delightful.

On verra bien.

— Mike


Why Tiger Is Going to Eat VC

Everett Randle @ Founders Fund wrote a thought-provoking essay on Tiger Global and its two structural innovations — maximizing deployment velocity & better / faster / cheaper capital for founders — that are upending growth-stage (ICT) VC investing. (“Playing different games”)


Great Wall of Capital: Part Deux

A few years ago I observed that seven Asia-focused buyout funds were in the market for $34B — a figure that was “on par with the aggregate hauls for EM PE funds in each of the last two years.”

Well.

Fast forward to today, and KKR has announced the close of its $15B Asian Fund IV. 

If the CalPERS & CalSTRS disclosures are anything to go by, the markups on Fund III appear quite good relative to those for Fund II, so the demand makes sense.

But.

If KKR keeps compounding its fund size at 9.9% each year, then they’ll be raising a $38B fund in a decade.

And that honestly doesn’t seem crazy anymore.

Either way, I don’t want to be writing about it.


Jamie Dimon & Fintech

Motive Partners highlighted the following passage from Jamie Dimon’s annual letter

Banks fiercely compete with each other and now face fierce competition from multiple vectors.

Banks already compete against a large and powerful shadow banking system. And they are facing extensive competition from Silicon Valley, both in the form of fintechs and Big Tech companies (Amazon, Apple, Facebook, Google and now Walmart), that is here to stay. As the importance of cloud, AI and digital platforms grows, this competition will become even more formidable. As a result, banks are playing an increasingly smaller role in the financial system.

Financial services are going to be integrated into everything. Legacy banks face daunting challenges.


The Saving Glut of the Rich

Fascinating paper.


From the Bookshelf

There are two forces: fate and human effort …
Two, since actions succeed neither by fate,
Nor sheer exertion alone, but through their bond.



Activated, human effort succeeds through fate,
And then that action’s fruit falls to the actor.
But even the effort of industrious men,
Working together, is fruitless in the
World devoid of fate.
Because of this, idle and unperceptive men
Despise exertion — the wise know better.
For generally action bears some productive fruit,
While to abstain altogether produces
Nothing but the heavy fruit of suffering.

Two kinds of men are seldom found — those who achieve
Their ends fortuitously, without exertion,
And those who, having acted, still do not succeed.
The industrious man, rejecting idleness,
Is fit to live; it is he, and not the idler,
Who increases happiness — it is he
Who desires the welfare of his fellow beings.
If the industrious man, through taking action,
Does not succeed, he should not be blamed for that —
He still perceives the truth.  

— The Sauptikaparvan of the Mahābhārata (Oxford World’s Classics: 1998)

# # #

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 2021, 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 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.

Bulls on Parade

The animal spirits are palpable. Though U.S. markets have seemed to be fully valued for some time, the price action since the ball dropped on 2018 is saying, “these go to 11.”

Jeremy Grantham of GMO captures the sentiment in his piece, “Bracing Yourself for a Possible Near-Term Melt-Up.” The punchline: Grantham says it’s possible that we’ll see a melt-up to 3,400–3,700 (!) on the S&P 500 over the next nine to 18 months. I mean, it’s possible (probable?) that we won’t, but I think he’s more right than wrong.

If you missed it, Grantham laid down a gauntlet of a thought exercise late last year: imagine that you are Stalin’s pension fund manager and you are told to generate 4.5% real returns for 10 years, or else. Where do you allocate your capital?

Grantham’s answer: EM equity. In size.

I imagine that many investors—particularly those with 7%+ return assumptions—are asking themselves the question: am I sufficiently overweight in EM?

Unfortunately, I don’t think that extends to EM private markets. However, a bull cycle in EM public markets should boost multiples and be conducive for exits. Here’s hoping that we see sustained portfolio and direct investment flows, and GPs seizing the opportunity to distribute capital back to their LPs.

Separately, thanks to those of you who encouraged people to subscribe to our newsletter. Our plea resulted in a donation to Room to Read, so thanks for contributing to children’s literacy.

Finally, If you missed our most recent research piece over the holidays, Does the EM PE Asset Class Scale?, it’s available for free on our website.

Happy new year. Let’s make it a good one.

Alla prossima,
Mike

McVey Calls a Secular Bull Market in EM

KKR’s Henry McVey issued his hefty investment outlook for 2018, “You Can Get What You Need.” The takeaway for readers of this newsletter is his conclusion that EM are in a secular bull market that should last for three to five years. Inshallah.

McVeyEM

Of note, McVey ran a DuPont analysis and discovers “that operating margins are finally improving across all of EM after a five-year bear market, which is now boosting return on equity.” Commodity-related companies are a major driver of this swing, so it pays to keep an eye on commodity prices for a potential turn.

One interesting tidbit in the outlook is his forecast for private equity returns over the next five years, which he estimates will decline to 9.6% (the highest across asset classes; see below).

McVeyReturns

Norway

No, not that story.

Norway’s $1.1 trillion sovereign wealth fund has submitted a recommendation to the finance ministry that it be given greater latitude to invest in and alongside private equity funds. This would be a fairly significant development for the private equity industry, given the volume of capital that it could unlock for the asset class.

In my dreams, I envision them building a team with a global mandate to identify small- and mid-cap managers with compelling strategies. Exploiting the advantage of being a genuinely long-term investor, and seizing the opportunity to build an edge in private markets.

But in my waking hours, I see billions flowing directly to Blackstone.

Brazil on the Move

Brazil’s auto industry is moving product: vehicle exports are expected to hit an all-time high of 750,000 in 2017, according to reports in the FT. We highlighted the bottoming process in Brazil in our April 2017 newsletter, when we juxtaposed the contraction in consumer lending and declining retail sales in the country with the fiesta in Mexico. If one were fishing for a macro long-short idea, this might be one place to look for pairs.

More to the point, we expect some large Brazilian funds to come to market in 2018. Will investors commit, or take a pass?

Not Interested

“Emerging market interest remained low this year.”

So concludes Probitas Partners, the global placement advisory firm, in its Private Equity Institutional Investor Trends for 2018 survey (n=98). Emerging markets are one of the least attractive segments within global private equity, with only 9% of respondents planning to focus their attention on EM this year (see below).

Probitas2

Managers in EM just are not a priority.

Within EM, surveyed LPs find China, India, and Southeast Asia most attractive, while ~15% of respondents express interest in LatAm and Brazil. Notably, 38% of respondents report that they do not invest in EM.

The full survey is available at this link (registration required).

From the Bookshelf

There are Croakers in every Country always boding its Ruin.

— Benjamin Franklin, Autobiography (Oxford World’s Classics: 1993).

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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.