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

———

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:

———

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.

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.

Dumb Money

In last month’s newsletter, I mentioned that I would be speaking at a conference with a bunch of LPs on the topic of “Global Markets for Buyouts and VC”. I closed saying, “Here’s hoping for an interactive, no-holds-barred session.”

Suffice it to say that my hopes materialized. While discussing the performance of EM PE, one LP said:

The issue with emerging markets is these funds have often been growth equity with minority stakes. The teams have been heavy on investment bankers who don’t know how to do deals. In emerging markets, private equity is the dumb money.

Dang.

Another discussion revolved around whether EM PE is in a cyclical downturn or a structural one. LPs’ commitments are generally pro-cyclical and many herd into markets / strategies at the same time, with predictable results. If so, then—ceteris paribus—the trickle of capital flowing to EMs (apart from mega-cap Asia … more on that below) may well signal a cyclical bottoming. As one conference delegate argued, now would present an optimal time to adopt a contrarian strategy and lean into EM PE.

Two brief rejoinders: First, this is not what LPs are saying they’ll do:

LP Sentiment

Second, this just isn’t how private markets work. Even if you wanted to do so, you can’t buy the index. You have to choose a manager.

Industry cycles and macro need to be disentangled. With that in mind, my view is that the quality of the managers in the market at a given time drives flows more than macro. The nuance is that fundraising is a bit of a coincident indicator: the managers with whom LPs wish to invest frequently come to market (a) at the same time; and, (b) when investor sentiment toward the jurisdiction in question is hot.

Alas, I’m still in the camp of this being a structural downturn. A few reasons I’ve pondered this week include:

  1. “Dumb Money”!
  2. David Swensen’s recent remark that “the breadth of emerging markets that we were interested in 20 years ago has narrowed dramatically.”
  3. DFIs, which historically have supported the development of the industry, are increasingly committing to later, larger funds.
  4. The ongoing emergence of local, non-PE investors that don’t face the same return hurdles / horizons creates greater competition for quality deals.
  5. Tech is disrupting everything; in markets with fewer, ephemeral exit channels, this is a big problem.

More importantly, Happy Thanksgiving to you and yours. One of the great bits of having a toddler is that I’m reminded daily that I have a blessed life. Thank you for being a part of it, and for welcoming this newsletter into your busy day!

Alla prossima,
Mike

The Great Wall of Capital

Fundraising for buyouts in Asia is robusto:

Seven funds. $34 billion. There are others.

That is a lot of granola; it’s on par with the aggregate hauls for EM PE funds in each of the last two years.

In other news, KKR inked a deal this month with Great Wall International to bring leveraged loans to China. There’s a joke in here about Barbarians at the Gate, but I’ll stop.

LP Views on Latin America

LAVCA teamed up with Cambridge Associates for the second time on their annual LP opinion survey. There are some interesting findings the study, such as the discovery that 53% of LPs considering a first investment in Latin America view currency volatility as the biggest impediment to investing in the region. (Recency bias?)

My favorite exhibit explores LPs’ preferred means of accessing LatAm:

LAVCA.jpeg

  • Most LPs plan to access LatAm via pan-regional funds
  • Brazil is the country of the future …
  • Proportionally, more Latin American LPs expect to access LatAm PE via global funds than international LPs (statistically insignificant, but the fact that they’re close strikes me as interesting)

Facebank

The societal parasite that is Facebook is entering the small business lending space, starting with merchant cash advances. This is a fairly fascinating development. The company has already effectively become the Internet for a large number of people; will it become a lender of first resort for small businesses? Given the vast swathes of data that Facebook collects, one might surmise that they could develop an edge in credit scoring that could benefit businesses with lower rates and Facebook with a large loan book. My interest is piqued.

In related news, EMPEA’s Q3 data show that capital invested in fintech companies through September ($416M) has already exceeded last year’s total ($379M). Aggregate fintech deal value is on track to match or exceed those for 2014 ($470M) and 2015 ($509M).

Turkey Resurgent?

Every so often, a leader steps up and makes a bold pronouncement, and market sentiment shifts. Think of Warren Buffet going long Goldman in the depths of the crisis, or Jamie Dimon plunking $26 million of his own cash on JPM shares in February 2016 (now up ~70%).

Has Seymur Tari of Turkven made a gambit to shift opinion in Turkey? Following a summer IPO of jeans retailer Mavi, Tari appears to be getting bulled-up on the market. Last month, Tari announced that the firm plans to list Medical Park Group in an offering that could fetch $1B. (Maybe?) Moreover, Turkven is planning to execute “three to four acquisitions of $50-400 million each in 2018 … and to start a new fund of more than $1 billion in one or two years,” according to Reuters.

I admire the verve. Turkey has been in the doldrums, and local business and consumer sentiment has been in a downtrend for seven years (see below). Is the tide turning?

Turkey2

From the Bookshelf

The quality of ideas seems to play a minor role in mass movement leadership. What counts is the arrogant gesture, the complete disregard of the opinion of others, the singlehanded defiance of the world.

Charlatanism of some degree is indispensable to effective leadership. There can be no mass movement without some deliberate misrepresentation of facts.

— Eric Hoffer, The True Believer (Perennial: 1966).

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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. 

 

Super Sized

Earlier this month I spoke with an MD at one of the largest private markets advisory firms about the landscape of managers in EM. While discussing the consolidation of capital in fewer, larger EM funds, he raised the question of whether this dynamic is a function of greater distributions from these funds.

While the data were too close to call in The Mid-Market Squeeze (DPI of ~0.5x across fund size segments), I decided to run a fresh analysis incorporating greater granularity on fund size and vintage year. The figure below shows that EM funds >$1B (orange) are not reliably distributing cash at higher rates than smaller EM funds (shades of blue). In addition, they are generally underperforming their >$1B peers in Asia, Western Europe and the United States (shades of grey).

DPI.jpeg

All in all, I’m not convinced that distributions from larger funds are driving industry consolidation. That said, analyses based on Cambridge Associates’ benchmarks do have their limitations. A fund-by-fund analysis may very well tell a different story.

In any event, this is one of several topics I’m looking forward to discussing next month in a closed-door session with ~100 LPs at the Private Equity Research Consortium Conference. I’ll be on a panel exploring “Global Markets for Buyouts and VC” with Professor Steven Kaplan from Chicago Booth, as well as representatives from Warburg Pincus and Adams Street Partners. Here’s hoping for an interactive, no-holds-barred session.

Alla prossima,
Mike

Indonesia’s First Startup IPO

Last month’s newsletter asked the question: Who Will Make Money in EM Venture? This month, we learned that Indonesia’s first IPO by a startup was … not venture backed.

“The path that startups take is normally to look for venture capital, angel investors and so on … We feel that by taking the IPO route, that’s the method that is the most fair and transparent,” said Jasin Halim, CEO of O2O e-commerce firm Kioson. Throwing shade on VCs, he continued, “Let the market value our company.”

And so it did, at an issuance price of IDR300 / share with a book that was 10x oversubscribed. It promptly proceeded to shoot the moon.

Regulators stepped in and temporarily halted trading this Tuesday (16 Oct.) to allow for a “cooling off” period. It resumed trading on Wednesday and closed at IDR2,650 / share. #9bagger

🎉

If the valuations for startups that go public trade at a premium to those held in private hands, Indonesia may be in store for a redux of the pre-IPO craze that hit China a few years back: alchemy in the form of public-private multiple arbitrage. The China parallel is a sentiment I heard from VCs in Jakarta over the summer, and though I’m always skeptical of comparisons to China, this is a space worth watching.

SoftBank

The PwC / CB Insights Q3 data are in and SoftBank, managers of the $93 billion Unicorn Bailout Fund—sorry, Vision Fund—took the top three spots on the league table for largest deals in the United States, and the top four spots on the league table for the largest global deals (Grab, WeWork, Flipkart, Roivant Sciences). And they’re just getting warmed up!

In other news, last month SoftBank placed a $20 billion bond sale (in 7- and 10-years), with the 10s priced at 5.125%. Market participants’ comments in the FT’s write-up of the sale should be preserved for future historians so that they fully appreciate the degree to which, in 2017, all caution had been thrown to the wind:

Everyone is asking the same question: what am I investing in here? Am I investing in a company’s operations or am I providing unsecured financing to fund equity contributions to the Vision Fund?

My view is that bond investors are thoroughly unimpressed, but they’re being sucked in by the price. I find the whole structure of the Vision Fund completely perplexing, but as it’s my job to make money, we were in the [order] book.

¯\_(ツ)_/¯

(SME) Death and Taxes in India

Saurabh Mukherjea of Ambit Capital is a bit of a downer on the impacts of New Delhi’s economic reforms on India’s (relatively unproductive) small businesses:

My reckoning is that for a substantial number of SMEs, their margin was tax evasion. As the government steps up forcing people to comply with GST, a lot of small businesses that managed to stay in the shadows will find themselves sucked into the tax net. Either their profitability will be vastly diminished — or it will go away completely.

How many companies globally would lose their margin if they actually paid taxes? I wonder.

Heavy Stuff

Last month the New York Times ran a provocative piece tying Nestlé to the rise of obesity in Brazil, which they followed up with an in-depth article on KFC in Ghana [full disclosure: Mike is a shareholder of NYT]. Regardless of one’s views on who / what is culpable for the deteriorating health of Brazilians and Ghanaians, (I mean, processed foods are certainly part of the problem), the fact is that Brazil and Ghana are not exceptions: lifestyle diseases are increasing rapidly across the emerging markets.

To wit, obesity rates are skyrocketing in each EM region (see below for a sampling). In China, the number of obese adults (≥ 30% body mass index, or BMI) has compounded at 9% since 1976, growing from ~3 million to more than 80 million, while the number of overweight adults (≥ 25% BMI) grew 7x over the period to nearly 400 million. There are more overweight adult Chinese than there are people in the United States and Canada combined. Astonishingly, on a global basis, the number of obese children and teenagers has increased 10-fold over the last 40 years.

Calories

In a similar vein, the number of deaths due to diabetes is growing rapidly. While roughly 62,000 people in Europe and the United States died from diabetes in 2015, representing a 6.4% increase on the figure for 2000 (entirely driven by Americans), nearly 600,000 died across EMs, representing a 64% increase over the same period (see below).

Lifestyles

It’s not solely multinationals that are driving the ubiquity in unhealthy eating habits and processed foods. Private equity firms have been enablers of these trends, tapping into the “emerging consumer” through deals in FMCG, quick service restaurants (QSR), etc. For example, Thomson Reuters data show PE firms have invested in 61 EM QSR companies over the last decade.

That said, you can’t say PE firms aren’t also investing in potential solutions—GPs inked twice as many deals (138) in hospitals and clinics over the same period. Nevertheless, one wonders about the firms that are “investing across the lifecycle”—selling obesity-inducing foods to local populations on the front end, and lifestyle disease solutions on the back end. A fairly perverse way of creating demand where none should exist, no?

From the Bookshelf

In the West, and among some in the Indian elite, this word, corruption, had purely negative connotations; it was seen as blocking India’s modern, global ambitions. But for the poor of a country where corruption thieved a great deal of opportunity, corruption was one of the genuine opportunities that remained.

— Katherine Boo, Behind the Beautiful Forevers (Random House: 2014).

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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. 

Status Update

It’s an exciting time at Portico as we mark our first anniversary in business. It has been a great year professionally and personally. I’m grateful to all of you who opened your doors for a meeting, picked up your phones when I called, shared our research with colleagues, and last but certainly not least, engaged us as a client. Thank you!

It ain’t an easy road, entrepreneurship. I underappreciated both the amplitude and frequency of the journey’s highs and lows before I got underway, but it is genuinely gratifying to wake up each day and create something of value for other people.

The best part of this endeavor is demonstrating to my son, through actions rather than words, that he should never be afraid to assume some risk and pursue the life of his choosing.

A few highlights from year one:

  • We assisted our clients through a variety of engagements, including strategy, fundraising, marketing documents and materials, pitchbooks, AGMs, custom research, and transaction advisory.
  • Portico released two original research pieces—Is Emerging Markets Private Equity Dying? and The Mid-Market Squeeze—which have been viewed over 1,000 times, and opened doors with firms we’d not yet met. Thank you again for reading and sharing!
  • We’re profitable with zero debt. At the outset of this adventure, I set a revenue target for December 2017. We beat it within 12 months of launch. Clear takeaway: aim higher and *get after it.*

All in all, it’s a great start out of the blocks, but we’re focused on staying humble, staying hungry, and identifying ways that we can deliver more value to our clients in the year ahead. I hope you’ll share the journey with us.

Alla prossima,
Mike

The Societal Parasite that Is Facebook

Speaking of Status Updates, John Lanchester has a superb article in the LRB (“You Are the Product”) on the societal parasite that is Facebook. Lanchester’s article came out before the NY Times [disclosure: Mike is a shareholder] revealed the company’s role in facilitating the information operations that influenced the U.S. election. (Oops!)

Frankly, the entire tech sector is overdue for greater regulatory scrutiny and enforcement. Whether it’s Airbnb, Alphabet (fka Google), Amazon, Facebook, or Uber, the laundry list of unpaid taxes, unethical conduct, and outright illegal activities never fails to astound. Firms active in emerging markets often speak about a “social license to operate.” At what point do these firms’ licenses get revoked?

Parenthetically, will Uber be the biggest write-off in the history of venture capital?

On a related note, we’ve mothballed Portico’s Twitter account. It’s a channel that doesn’t deliver value for the company, so we will not spend energy on it.

Who Will Make Money in EM Venture?

Henry Nguyen of IDG Ventures Vietnam made some thought-provoking comments at an AVCJ event in Ho Chi Minh City a few months ago. In a nutshell, he noted that the tech giants—Alibaba, Alphabet, Amazon, Facebook, and Tencent, among others—have radically transformed the venture ecosystem. Not only are these companies scouring the same landscape for deals as VCs, but they’re also doing so with the advantages of: 1) a longer time horizon; and, 2) a lower cost of capital.

These seem like … insurmountable advantages for an investor?

Intuitively, this might leave some space for early-stage investors to front-run their later stage and corporate venture peers; but, I do wonder.

What I don’t wonder about: whether entrepreneurs will build great companies, or whether economic value will be created. These are certainties. The question is: who will capture the value?

I suspect a number of LPs in EM venture funds are asking themselves the same question. Having seen individual deals rocket in value, LPs are seeing appetizing write-ups on paper, but they remain hungry for realizations (see below).

Mind the Gap

This World Awash in Capital

Consider the following. Since 2006:

We have been living amidst a transition from a world in which financial capital was relatively scarce to one in which it has become abundant. Bottlenecks remain, of course, and there’s ample room to expand access to finance for productive enterprises, particularly in our geographies. Nevertheless, this development has profound implications, and I’ve been pondering a few thoughts as of late:

  • Corporations are asset managers. Thirty U.S. companies hold more than $800 billion of *fixed income* investments. This sum is greater than the combined AUM of Blackstone, Apollo, KKR, and Oaktree.
  • Passive investing is a freight train. If capital is becoming commoditized, why should managers earn excess fees for investing it? Investors are voting with their feet en masse, with upwards of 40% of AUM now managed through passive vehicles. Vanguard’s AUM hit $4.4 trillion in the first half of 2017 (up from ~$1.6 trillion as of year-end 2011).Prices go up when there are more buyers than sellers. Therefore, in a world awash in capital, the biggest driver of performance is fund flows. If flows are channeling into ETFs and index products, then active managers that don’t buy the index will have a hard time outperforming, let alone justifying their fees (and most of them aren’t worth the fees to begin with). The passive trend is likely to end in tears, with a resurgence in fundamental-driven investment one day; but this freight train is leaving destruction in its wake.
  • There is a scarcity of assets. The stock of quality, publicly available, investable assets is not keeping pace with the growth in global savings. To take one example, the number of publicly listed domestic companies in the United States has declined by 46% over the last two decades. Or, consider the rapidly growing pension schemes across emerging markets, whose asset bases are growing faster than investment managers can find places to invest it prudently.The relative scarcity of investable products leaves markets prone to bubbles and the misallocation of capital. The rise of passive investing and ETFs only exacerbates this problem.
  • Private markets hold opportunity. Given their inherent inefficiency, private markets are likely to remain an attractive place to deploy capital (though not necessarily via traditional LP-GP structures). Technology-based platforms already exist to intermediate private transactions within the United States, and we should expect these to develop globally, as owners of capital climb further out the risk curve and get more hands-on with co-investment and direct investing.
  • U.S. housing is a political time bomb. The stock of housing is neither keeping pace with the growth in population, nor accounting for the impact of cross-border flows on housing supply.For example, foreign buyers accounted for 10% of the value of existing U.S. home sales between April 2016 and March 2017, and they’re increasingly buying houses that are out of reach for most Americans. To wit, the average price for all U.S. home purchases grew at a CAGR of 5% from 2010-2017. Meanwhile, the prices paid by foreign buyers grew at 8%, and those by Chinese buyers grew at 10%s. Moreover, while 50% of Americans can’t afford a down payment and 30% can’t secure a mortgage, 72% of non-resident foreign buyers paid all-cash (see below).

housingtimebomb1housingtimebomb2

From the Bookshelf

The world is always full of the sound of waves.

The little fishes, abandoning themselves to the waves, dance and sing and play, but who knows the heart of the sea, a hundred feet down? Who knows its depth?

— Eiji Yoshikawa, Musashi (Kodansha International: 1995).

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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. 

The Mid-Market Squeeze

In recent months, I’ve enjoyed some great conversations with individuals who have welcomed a frank discussion of the EM PE industry’s challenges. One recurring topic of conversation is the imbalance between supply and demand for capital for PE funds operating in the lower- and mid-market segments in EMs.

The hollowing out of mid-market funds animated my decision to found Portico, and it served as the impetus for our EM Mid-Market Survey, which we conducted in May. I am pleased to announce the release of Portico’s second research piece, The Mid-Market Squeeze, which shares findings from our survey.

We undertook this project with two objectives in mind: (i) to test our hypotheses for the supply-demand imbalance; and (ii), to illuminate potential paths toward solutions.

Most of our hypotheses were affirmed, in whole or in part, but the report’s overarching finding is that the declining number of EM mid-market funds is more than just a funding gap, it is a symptom of industry-wide problems. Our survey reveals four drivers for the mid-market squeeze:

  • Macroeconomic developments in EMs are not the reason why LPs aren’t committing to mid-market PE funds; it’s the failure of EM PE funds to deliver returns.
  • There is an acute funding gap for EM PE funds smaller than $100 million in size.
  • Development finance institutions are walking away from smaller EM PE funds, and investing with larger, more established firms. Moreover, their preferred ticket sizes are in the sweet spot of where commercial LPs prefer to play.
  • Institutional investors lament the lack of transparency in the EM PE industry.

The report offers a few thoughts on potential solutions to the mid-market squeeze, and prognostications on the road ahead. I invite you to click the button below to download a copy of the report. Please feel free to share it with colleagues, and of course, all feedback is welcome.

Finally, thanks go out to the 76 industry professionals who participated in this survey, as well as the winner of our prize drawing—a representative from an Asia-Pacific sovereign wealth fund—who selected the donation to UNICEF.

Alla prossima,
Mike

Indonesia: So Hot Right Now

Having freshly returned from a trip through Southeast Asia, I was interested to see KKR’s Henry McVey release a new report on Indonesia, stating:

Indonesia has one of the most compelling stories that we see … and unlike in past trips, we are now confident stating that we think Indonesia is harnessing its potential into near-term economic and investment realities.

The macro is certainly compelling, and there are reasons to be optimistic (not least the forthcoming rail line connecting the airport with downtown).

I agree with McVey that “public market indices are often not the appropriate investment vehicles to actually gain access to compelling GDP-per-capita stories;” and based on my own meetings in the country, I share McVey’s conviction that there are attractive tech opportunities in private markets (see charts below). KKR is actively pursuing this thesis, having invested alongside Capital Group Private Markets, Farallon Capital Management, and Warburg Pincus in the local ride-hailing / transportation company GO-JEK last year.

Still, translating the macro into compelling investment returns requires deft navigation. One dynamic working in mid-market managers’ favor is the general scarcity of capital; there is less competition for deals from other financial sponsors in this segment, though local families and investors play an important role in the private markets ecosystem. The game changes once tickets climb north of $100m, where a large volume of PE capital is searching for deals.

KKR_Indonesia

Coffee Talk

In our April newsletter we highlighted the rise of secondary buyouts as an exit channel in Africa, and there’s big news from ECP portfolio company Nairobi Java House. Abraaj won the auction for the company, which reportedly drew 12 non-binding bids (including from Carlyle and TPG). Abraaj shall take full control of the company, which includes two additional franchises: Frozen Yoghurt and 360 Degrees Artisan Pizza. By my count this is Abraaj’s third secondary buyout in Sub-Saharan Africa out of four deals since 2014 (Mouka from Actis in 2015, Libstar from Metier in 2014).

While Abraaj has some experience in the QSR segment (Kudu in Saudi Arabia), and I’m curious about potential synergies with its investments in Brookside Dairy, Fan Milk, and Libstar, the firm has its work cut out for it. I struggle to think of an East African firm that has been able to achieve pan-African scale.

One experienced advisor in the region tells us:

The pan-African strategy is very difficult to execute due to: (a) the small size of most of Africa’s 40+ markets, which means you’re spreading the fixed costs of market entry across a small customer / revenue base; (b) the high cross-border costs of trade, which makes supply chains expensive to run; and (c), the economic, regulatory, and cultural differences between East, West, and Southern Africa. The difficulties cut in every direction.

While Ecobank is a partial exception (it has a long way to go to become a consolidated, sustainable business with deep insight into all of its local markets), the failures are numerous. For example, United Bank of Africa, which has met success in its home market of Nigeria, got burned in Kenya. South African retailers, such as Shoprite and Massmart, have struggled to gain traction north of the Limpopo.

The general lesson I draw is that African markets do not have a broadly even playing field. Any attempt to expand beyond one’s own region will only work if you make a massive investment, and you bring in heavy hitters with political influence. A more sensible strategy is to aim to become the number one player in your region rather than overstretching by seeking a continental presence.

🤔

Will Private Equity Build Africa’s Manufacturing Sector?

No.

The FT recently ran a comment piece imploring PE firms to drive the development of Africa’s manufacturing sector. Private equity can deliver—and has delivered—powerful developmental impacts in Africa. For example, an impact assessment of CDC Group plc’s Africa fund investments between 2004-12 shows direct job creation of 40,500 positions and a $600 million increase in taxes paid. I’m a believer in the potential of the asset class to deliver dignity in EMs; however, some of the author’s overzealous assertions bear some scrutiny:

Private equity has largely ignored investment in African manufacturing and industrial projects. [EMPEA] data show that 23 PE firms have made only 53 investments in the industrials sector in Sub-Saharan Africa since 2008.

PE firms have not ignored African manufacturing companies. First, by excluding deals in manufacturing companies outside of the industrial sector (e.g., consumer durables, food and beverage), the data understate the volume of investments that have been made in manufacturers.

Second, how many manufacturing companies are there in Africa? Within the industrials sector, according to Thomson Reuters Eikon there are only 57 private African companies generating between $50m and $500m in revenue.

Middle market funds, in particular, have an enormous opportunity to unlock potential in this sector. Doing so will … create value for investors by creating a robust deal pipeline with attractive exit opportunities …

Maybe? There have been—and will be—some excellent returns from manufacturing deals in Africa; but has the traditional EM PE model created value for investors?

According to Cambridge Associates’ African Private Equity & Venture Capital Index, the 10-year horizon pooled return is 4.51%, and the pooled return has not exceeded 5% over any multi-year period. This may be a function of the constituents in Cambridge’s database—Ethos, for example discloses a USD gross IRR of 20% since its third fund—but the pooled return suggests investors are taking on equity risk + country risk + illiquidity, and receiving 200 basis points over 10-year Treasurys.

With this return profile, why should pensioners, endowments, and foundations be subsidizing African industrial policy?

On a related note, McKinsey Global Institute released a fascinating report on Chinese investment in Africa that shows who is likely to drive the growth of manufacturing on the continent: Chinese firms. McKinsey estimates that there are more than 10,000 Chinese firms operating in Africa—3.7x more than previously estimated—and nearly one-third of them are in the manufacturing sector (generating ~$60 billion in local revenue, with 12% market share). Says McKinsey:

In sectors such as manufacturing, there are too few African firms with the capital, technology, and skills to invest successfully and too few Western firms with the risk appetite to do so in Africa. Thus the opportunities are reaped by Chinese entrepreneurs who have the skills, capital, and willingness to live in and put their money in unpredictable developing-country settings.

In the Beach Bag

Jul17Books

I don’t know if these are the books I’ll end up reading, but here’s what I’m planning to pack for the beach this year:

  • Business Adventures, by John Brooks
    The “best business book” say Warren Buffett and Bill Gates.
  • Evicted: Poverty and Profit in the American City, by Matthew Desmond
    Most Americans are one accident away from financial ruin: 25% can’t pay their monthly bills in full, and 44% can’t meet a $400 emergency expense. Desmond’s book looks at the precarious state of Americans’ living situations. In Milwaukee, for example, “a city of fewer than 105,000 renter households, landlords evict roughly 16,000 adults and children each year.”
  • The Devils of Loudun, by Aldous Huxley
    I quite enjoyed Huxley’s Grey Eminence, which chronicled the life of Father Joseph—advisor to Cardinal Richelieu and advocate of policies that led to the Thirty Years’ War—so I thought I’d return to the trough for his take on mass hysteria and witch hunts in 17th-Century France.
  • The Demon in Democracy: Totalitarian Temptations in Free Societies, by Ryszard Legutko
    A Polish freedom fighter contemplates the similarities between liberal democracy and communism.
  • Technological Revolutions and Financial Capital: The Dynamics of Bubbles and Golden Ages, by Carlota Perez
    A recommendation from Marc Andreessen.
  • The Thirty Years War, by C.V. Wedgwood
    With talk of the Westphalian system’s decline, why not read Dame Wedgwood’s classic for a refresher on the madness that led to the peace?
  • Musashi, by Eiji Yoshikawa
    A novel chronicling the life of the infamous samurai, and teacher of bushido, Miyamoto Musashi.

From the Bookshelf

I have given up newspapers in exchange for Tacitus and Thucydides, for Newton and Euclid; and I find myself much the happier.

— Thomas Jefferson, letter to John Adams, 21 January 1812 (Monticello, Virginia).

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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.