Liquefaction

Liquefaction | ˌlikwəˈfakSH(ə)n | noun
a process that creates a liquid from a solid (basically)

I’ve been wrestling with the idea of entropy in international affairs for the last five years or so. During my travels to London a couple weeks ago, Brexit peppered most every conversation, and I found myself thinking about political instability and its implications for investors.

The global landscape has transformed from solid to fluid, whether at the level of the international system, the state, or the individual. While the “decline of the liberal international order” has been debated ad nauseum, it’s fairly clear that we are transitioning from the post-World War II system to a new one. The problems seem to be that: (1) nobody knows what the new system should be; and, (2) no leaders are guiding us toward one.

That may be due to the fact that national leaders have more pressing priorities. How are leaders meant to identify principles of unity amongst nations when disunity and discord are ascendant at home — and, indeed, actively stoked to win at the polls?

Our populist and reactionary politics are a symptom, not the disease. At bottom, across developed and emerging markets alike, the social contract is broken.

As bleak as things are, it’s worth remembering that one of the benefits of democratic governance is that these fissures are out in the open. People are free to talk about them. The steam can be released. Society and institutions can adapt.

So, amidst all this political instability I’m beginning to think that the greatest risks in this brave new world come from the presumption of stability where none, in fact, exists.

And while I’m at it, I detect an astonishing degree of complacency toward one market in particular: China.

According to EMPEA’s Industry Statistics, $84B of capital has been raised for China-dedicated PE funds over the last five-and-a-half years, with scores of billions in regional funds that will invest in the country.

There seems to be a presumption that, since the country and its currency have been stable, this state of affairs will continue. That’s not how things work. Everyone’s legal disclaimers say as much (“Past performance is not indicative of future results …”).

I shared my rule #1 on China last month (“nobody knows anything about China — especially me”), but China’s fragilities are increasing. And a certain someone in the White House seems to smell it.

Will the country’s political system be able to respond to current and future challenges? In a manner that’s aligned with the interests of international capital?

I have my doubts.

At the very least, confidence intervals should be adjusted.

My conclusion: the most valuable attribute in EM private markets going forward is a flexible mandate.

There will always be a place for focused specialists, especially managers who bring bona fide operational expertise and can genuinely build businesses. However, in a fluid global landscape, flexibility is key — whether geographic, along the capital stack, or even across asset classes.

It’s time to think different.

Anyway, Portico has been busy in all corners during this harvest season, but particularly in Latin America, which remains a manifestly underappreciated region (see below).

Things are also a tad hectic on a personal level, as our family’s expecting the arrival of our second son / first little brother next month. If there’s no newsletter in November, well … entropy.

Alla prossima,
Mike

Herd Behavior

EMPEA released its 1H 2018 industry statistics and the concentration of capital in Emerging Asia is astonishing. Across private equity strategies (i.e., buyout, growth, and VC) Emerging Asia captured $24B — 93%! — of EM fundraising in the first six months of the year (that’s up from 77% in full-year 2015).

Only $1.85B was earmarked for PE managers active in Africa, Central & Eastern Europe, Latin America, and Pan-EM.

As usual, it’s worse than it appears.

That $1.85B figure overstates the volume of U.S. dollar investors committing capital to EM managers. Consider that the largest PE funds achieving a close in each region ex-Asia raised only $382m in USD, but $1.1B in local currency vehicles (see below).

Screen Shot 2018-10-24 at 11.36.46 AM

I get that political uncertainty has stalled many Latin American managers’ fundraising plans, but $24m in USD? WTF?

Meanwhile, the forward calendar in Emerging Asia (inclusive of closes in Q3) has over $50B of USD-denominated funds in market (e.g., Hillhouse, Baring Asia, CVC, PAG, TPG, etc.).

I’ve disclosed Portico’s interest, but if ever there were a contrarian play in EM PE …

KYC

Fred Wilson of Union Square Ventures put out a heat-seeking missile of a blog post on Sunday (Who Are My Investors?). You should read it.

Fred’s musings were prompted by a note from one of USV’s portfolio company CEOs, who said:

I need to know if any of your LPs include ……….  entities/interests.

This is a super interesting and welcome development, and I think Fred’s right to conclude that the quality of a fund’s LPs will impact deal flow … at least in U.S. venture.

A few quick reactions:

  • The cynic in me wonders if this sentiment is a luxury of a world awash in capital. But then, maybe founders with vision are the scarcest thing around.
  • For all the asset managers clamoring after Millennial money with impact strategies, it’s notable that founders are saying they want to partner with ethical investors who share their values.
  • We’ve talked a lot about transparency and governance in this newsletter this year, and it’s intriguing to see a dialogue emerge about information flowing down to the portfolio company, and not just up to the fund.

Anyway, in case you don’t click through to Fred’s post, his bold conclusion follows:

It is time for all of us in the startup and VC sector to do a deep dive on our investor base and ask the question that the CEO asked me. Who are our investors and can we be proud of them? And do we want to work for them?

Not all money is the same. The people that come with it and who are behind it matter. That has always been the case and remains the case and we are reminded of it from time to time. Like right now.

Add-Backs

The thing about dealing with leveraged buyout firms is that you always know who the Muppet isn’t.

Let’s say you’re a leveraged lender. A Patrick Bateman clone shows up and presents his bone-colored business card along with pro forma financials showing “adjusted EBITDA” for a company they’d like to lever at 6x.

You ask some questions about his revenue growth and efficiency gain assumptions, which seem slightly … optimistic.

But also, you don’t want to get fired for turning away business from a Very Important Client Who Always Gets What He Wants.

Meh, it’s not your money.

So the loan gets funded, and some teachers’ pension in Dubuque or wherever ends up holding the paper.

A couple years later, as you’re clearing out your desk, you find Bateman’s business card and you remember the discussions about the adjusted EBITDA. And since you’ve just been fired, you have time to look up what happened to that company. Did they grow revenues? Did they capture those efficiencies?

If your research reveals anything like a recent analysis by S&P Global Ratings, you’re likely to find that Bateman’s adjusted EBITDA turned out to be slightly … optimistic.

Says Institutional Investor:

In an analysis of companies involved in deal making in 2015, S&P found that the earnings projections were unrealistically high on average across leveraged buyouts and mergers due to so-called “add-backs” — adjustments made to account for expected cost savings or an anticipated rise in revenue … Compared to companies’ projections, EBITDA … turned out to be 29 percent lower in 2016 and 34 percent lower last year.

The good news is: (1) tallboys of Tecate come with a shot of Fidencio at El Rey’s tonight; and, (2) your mom’s pension invested in the LBO fund.

So when Bateman & Co. jammed through the inevitable dividend recap, the probability of your mom living on cat food declined by a few basis points. Unlike those sad souls in Des Moines or wherever.

Every cloud has a silver lining.

¡Salud!

Public Companies and Short-Termism

The U.S. Federal Reserve Board conducted a study to investigate the investment tendencies of public and private firms. Using corporate tax returns, the economists determined that — contrary to popular belief — “public firms invest substantially more than private firms.”

Says the study:

Relative to physical assets, publicly-listed firms invest approximately 48.1 percentage points more than privately-held firms … predominantly driven by long-term assets: public firms invest 6.5 percentage points more in short-term assets, and 46.1 percentage points more in long-term assets than their private firm counterparts … The access to capital investment and the ability to spread risks among many small shareholders appears to facilitate heavier investments in R&D, arguably the riskiest of asset classes.

You learn something every day.

And who knew R&D was an asset class?

Impact Investing

I don’t know about you, but I find it a bit difficult to wrap my head around “impact investing.” The term is as slippery as a greased pig.

IFC has stepped into the breach and developed, in consultation with asset managers and investors, a set of Operating Principles for Impact Management. The draft document establishes nine principles across the following five elements:

  • Strategic Intent
  • Origination & Structuring
  • Portfolio Management
  • Impact at Exit
  • Independent Verification

IFC is inviting reviews from stakeholders through the end of the year, so if you have an opinion, please share it. With IFC.

From the Bookshelf

Thus they were able to recall the past in the hope of finding new wisdom rather than in awe of its immutable commands; they could think of the future as a time of promise rather than of certainty; and they could use the present as an opportunity for the exercise of choices rather than for compliance with preordained patterns of life.

— Adda Bozeman, Politics and Culture in International History (Princeton University Press: 1960)

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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.

 

First Move

It has been five months since we released our first research piece, Is Emerging Markets Private Equity Dying?, and though Portico is still in its infancy, we’re excited about the doors this study continues to open, and the conversations we’ve been having with firms across geographic and market cap segments.

Two recent developments suggest that the trends highlighted in Is EM PE Dying? are unlikely to reverse anytime soon:

  • Fundraising data from EMPEA show that the number of final closes for funds <$250m in size continues to decline; meanwhile, capital raised for EM VC and private credit funds has reached all-time highs.
  • Apparently IFC is looking to commit up to $25m to Carlyle’s fifth Asia growth fund, underlining the trend of DFIs supporting established fund managers (that probably should have graduated from DFI capital).

Keep your eyes peeled for Portico’s forthcoming Middle Market Survey. We’d truly value your input. For those suffering survey fatigue, there will be a prize drawing for a Year in Books Subscription from the delightful booksellers at Heywood Hill in Mayfair.

Best wishes,
Mike

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Coming to Southeast Asia in May

I’ll be traveling through Southeast Asia next month, with stops planned for Singapore, Jakarta, and HCMC. I’m looking forward to (re-)connecting with several firms, and to kicking the tires on a hypothesis that the region presents a qualitatively different opportunity set than was on offer five years ago. Back then, investors got bulled up on the region, but had questions about the investable market. Have things changed? (It’s a small sample, but Cambridge Associates Benchmark data show TVPI of 1.07 for 2010-13 vintage Southeast Asia funds).

I’m particularly excited about the visit to Vietnam, where there have been some big deals taking place, including:

  • KKR’s $150m transaction in Masan Nutri-Science, continuing the firm’s quality food thesis (seen with its Modern Dairy and COFCO Meat deals in China);
  • VinaCapital’s joint venture with Warburg Pincus to create a hospitality JV (valued at up to $300m); and,
  • TPG’s intention to acquire a stake in Vietnam Australia International School, providing a potential liquidity event for Mekong Capital.

If you’re in the region, I’d love to meet with you. Drop me a line and I’ll try to find a time that works for you!

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Deal Flow in Africa

AVCA and EY released their latest study on exits in Africa, and the data point that jumps off the screen is the rapid growth of secondary buyouts as an exit channel, which hit *17* last year. There haven’t been more than 7 secondary buyouts / year going back to 2007.

The other dynamic at play—and I haven’t pulled data on this, so it’s just an impression—is a steady drumbeat of GPs co-investing in deals on the continent. Taken together, these two dynamics suggest that deal flow may very well be an issue in Africa (at least for firms managing traditional 10-year, closed-end structures).

But at the same time, the clear growth in secondary buyouts and (suspected) increase in GP co-invests may not necessarily be a bad thing. We could be witnessing a phenomenon similar to tier one PE / VC in the United States, where sequences / consortia of private capital investors scale up winner-take-most (if not all) platforms, or build out category leaders with decent moats. Time will tell!

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The Gift that Keeps on Giving in Eastern Europe 

Speaking of secondary buyouts and private capital building category leaders, Zabka Polska—operator of convenience stores, Freshmarkets, and supermarkets—has been sold to a PE buyer once again. Over the last 17 years, Zabka has changed hands from:

PineBridge Investments Penta Investments Mid Europa CVC

The company’s growth over the last two decades is truly astonishing. For its part, Mid Europa reportedly fetched €1.1B after growing Zabka’s top- and bottom-lines 3x and 4x, respectively, and opening 500 stores / year. Na zdrowie!

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Consumer Sentiment in Latin America

It’s not a good idea to try to call tops or bottoms—so I won’t—but one of the data streams I’ve been monitoring with interest is consumer sentiment in Brazil and Mexico. Given the political and economic turmoil in the former, and the fact that average manufacturing wages have been flat for a decade in the latter, it’s little surprise that consumers in these countries have been gloomy for five years running.

And yet, since the beginning of 2015, there has been a marked divergence in retail sales volumes across these two markets. Brazilian retail sales have declined in line with a contraction in consumer lending. By contrast, Mexican retail sales have been on a tear, fueled, in part, by a rapid expansion in household credit.

Brazilian consumer confidence is recovering, as are retail sales, and consumer credit growth remains restrained. Though the politics are slippery, it appears like a bottoming process is at hand. Mexico’s debt-fueled consumption binge, however, gives one pause. It’s hard to look at the chart below without contemplating a parallel to the morning after a night out in La Condesa, having imbibed too much mezcal and consumed too few tacos.

LatAmConsumer

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From the Bookshelf

Earlier this year, I read Carroll Quigley’s Evolution of Civilizations (1961). One of Quigley’s core arguments is that societies create instruments to meet basic human needs (e.g., security, the accumulation of wealth and savings, etc.), but these instruments evolve into institutions, which over time become less effective at achieving their original purposes.

When discussing the interwar period (1919-39), Quigley makes an insightful point about the evolution of the economic system that seems germane to today’s debates about secular stagnation.

The purpose of any economic system is to produce, distribute, and consume goods … As [the economic system] became institutionalized, profits became an end in themselves to the jeopardy of production, distribution, and consumption.

The rub is that the expansion of profit margins through higher prices and lower costs of production ultimately reduced consumption, and increased wealth inequality. Quigley continues:

Such an inequitable distribution of wealth was a very excellent thing as long as lack of capital was prevalent in the economic system, but such a maldistribution of income ceases to be an advantage as soon as the productive system has developed out of all proportion to the processes of distribution and of consumption.To some extent this situation was made worse by the growing separation … between ownership and control of corporations, since this led to an increased accumulation of undistributed profits held by the corporations in control of the management rather than distributed as dividends to the owners. Such undistributed profits became savings with no possibility of serving as consumer purchasing powerIncreasing proportions of the national income were going to those persons in the community who would be likely to save and decreasing proportions were going to those persons in the community who would spend their incomes for consumers’ goods.

As someone who genuinely believes in long-term investment, the passage above left me wondering whether this world awash in capital—one in which U.S. after-tax corporate profits (net dividends) amount to $982 billion (see below) and the pension assets of 22 countries total $36.4 trillion—is one that consigns us all to Keynes’s paradox of thrift.

USCorpProfits

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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.