A CDO for Secondaries?

A year or so ago I floated the idea of an index fund for EM private assets.

What if there were an asset manager that could agglomerate a sufficient pool of capital through a publicly listed vehicle (e.g., a super-SPAC) to go out and purchase — in whole or in part — scores of PE-backed companies across EM?

Would a diversified portfolio — at scale — provide better risk-adjusted returns than existing public and private equity funds? 

My bias had been toward equity.

But what if the answer is debt? 

And not just any kind of debt, but securitized debt?

 * * *

Andrew Lo — Director of the MIT Laboratory for Financial Engineering — recently gave a fascinating lecture on new funding models for biomedical innovation as part of the Markus’ Academy series of webinars at Princeton’s Bendheim Center for Finance.

Lo argues that, whilst we’re living amidst a revolution in a variety of ‘omics’ (e.g., genomics, proteomics, microbiomics), to actualize and commercialize scientific and medical advancements, we need a revolution in economics — particularly in how we finance innovation.

At first glance it might seem like an odd proposition.

Even if U.S. venture is exhibiting a ‘diversity breakdown,’ biopharma companies are sitting on $1.5 trillion in ‘firepower’ to fund transactions.

Isn’t there enough funding available already?

Lo asks us to ponder whether it’s worth making a $200m investment in something with the profile of a single anti-cancer compound (i.e., 5% probability of a positive payoff after 10 years of R&D). If successful, annual profits would be $2B / year for 10 years (a present value of $12.3B).

At a 95% failure rate, investing makes little sense.

But Lo points out that if you could invest in 150 programs simultaneously (totaling $30B of capital), the probability of 3 successes out of 150 attempts is 98.18%, and the Sharpe ratio increases from 0.02 to 0.34.

* * *

What if we translate this idea to the EM private markets index?

Would we see:

  • A lower cost of capital for EM companies?
  • Longer runways for value creation?
  • Higher risk-adjusted returns for investors?
  • Lower fees?
  • Greater liquidity (e.g., coupons)?

I don’t know.

But I wonder: maybe — maybe — the solution for the artisanal industry of EM private markets is diversification and massive scale?

— Mike


Viktor Shvets on The Great Rupture

In the latest episode of the Portico Podcast, I speak with Viktor Shvets, a global strategist at Macquarie, and the author of the deeply thought-provoking book The Great Rupture, which investigates the past and interrogates current trends to probe the question: do we need to be free to be innovative, prosperous, or even happy?

You may want to grab a pen and some paper to take notes for this episode because Viktor is a polymath who will engage your brain in some important — and at times, unsettling — thought experiments.

Viktor and I discuss:

  • Why he wrote a book that looks for lessons in the 12th to 15th Centuries to guide us through the next two decades;
  • Whether the ‘operating system’ of open markets, property rights, and open minds that generated prosperity in the past is in retreat — and even if it were, would it matter;
  • The confluence of the information and financial revolutions, and how these two forces are hollowing out the core frameworks of society;
  • The state’s usurpation of the free market and what it means for capitalism and commercial banking;
  • The prospects for emerging markets in an era of de-globalization and the importance of EMs’ non-tradable sectors;
  • Whether universal basic income might liberate people from scarcity and empower them to live lives of their choosing.

But there is so, so much more.

Check it out on Apple Podcasts | Google Podcasts | Spotify


Does PE Investment in Healthcare Benefit Patients?

No.

  • “Our estimates show that PE ownership increases the short-term mortality of Medicare patients by 10%, implying 20,150 lives lost due to PE ownership over our twelve-year sample period. This is accompanied by declines in other measures of patient well-being, such as lower mobility, while taxpayer spending per patient episode increases by 11%.”
     
  • “We find that going to a PE-owned nursing home increases the probability of taking antipsychotic medications — discouraged in the elderly due to their association with greater mortality — by 50%.”
     
  • “We find that PE ownership leads to a 3% decline in hours per patient-day supplied by the frontline nursing assistants who provide the vast majority of caregiving hours and perform crucial well-being services such as mobility assistance, personal interaction, and cleaning to minimize infection risk and ensure sanitary conditions. Overall staffing declines by 1.4%.”
     
  • A puzzle is why nursing homes are attractive targets given their low and regulated profit margins, often cited at just 1-2%. Using CMS cost reports, we find that there is no effect of buyouts on net income, raising the question of how PE firms create value. There are three types of expenditures that are particularly associated with PE profits and tax strategies“monitoring fees” charged to portfolio companies, lease payments after real estate is sold to generate cash flows, andinterest payments reflecting the importance of leverage in the PE business model (Metrick and Yasuda, 2010; Phalippou et al., 2018). We find that all three types of expenditures increase after buyouts, with interest payments rising by over 300%. These results, along with the decline in nurse availability, suggest a systematic shift in operating costs away from patient care.”

Bain’s Global PE Report

A few highlights from the year in review:

  • Global buyout deal value reached $592m (up 8% yoy) whilst deal count declined by 24%;
     
  • ~70% of U.S. buyouts were priced above 11x EBITDA whilst ~80% of deals are leveraged 6x or greater; and,
     
  • The number of global buyout exits appears to have fallen below 1,000 — the worst year since 2009.

Hugh MacArthur and Mike McKay ask: Have classic buyout funds run their course?

When I look at the data points highlighted above, I think the answer will turn out to be a resounding ‘yes.’

MacArthur and McKay point to the rise of specialist funds, carving out space for a discussion on the evolution of Vista’s strategy, among other things.

Look. Buyout firms absolutely need a differentiated value proposition.

But in a world of capital superabundance, the average buyout firm offers declining utility as an allocator of capital.


Governance

Speaking of Vista.
 
By now you will have heard that Vista’s founder, Robert Smith, struck a non-prosecution deal with the U.S. government in which he admitted to evading taxes for 15 years.
 
There are some lawsuits alleging mismarked assets and self-dealing.
 
Amidst all the talk about ESG, do institutional LPs value good governance?
 
In the case of Vista, one seems to. Several don’t.
 
But it’s a much bigger question (Abraaj: Redux 👀).

Do institutional LPs actually do their homework on larger funds?
 
Or are the investment teams too cozy with their contractors?


Zhou Xiaochuan and the eRMB

Caixin / Nikkei Asia published an important article from former PBOC governor Zhou Xiaochuan on the landscape for a digital renminbi. This is a space worth watching.


From the Bookshelf

Human history is indeed filled with endless possibilities; and the Renaissance saw this more clearly than either classicism, Catholicism or the Reformation. But it did not recognize that history is filled with endless possibilities of good and evil. It believed that the cumulations of knowledge and the extensions of reason, the progressive conquest of nature and (in its later developments) the technical extension of social cohesion, all of which inhere in the “progress” of history, were guarantees of the gradual conquest of chaos and evil by the force of reason and order. It did not recognize that every new human potency may be an instrument of chaos as well as of order; and that history, therefore, has no solution of its own problem.

— Reinhold Niebuhr, The Nature and Destiny of Man: Volume II. Human Destiny (Charles Scribner’s Sons: 1964)

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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.

New Frontiers

A review of the accounts reveals that Covid-19 drove a 60% decline in Portico’s revenues compared to our 3-year average.

Oof.

Not keen to repeat that gut punch.

Onward.

I’ve been thinking about the mission that animated me to launch Portico ~5 years ago: closing the finance gap through the creation and dissemination of knowledge.

As it says on our website:

Though the world is awash in capital, a variety of bottlenecks inhibit its flow to productive users of financing — particularly in markets where capital is a relatively scarce factor of production.

I conceived of the finance gap through the prism of geography, in large measure because that’s where my journey started.

However, there are other “markets” where capital scarcity is a pernicious problem.

At its core, Portico helps carve out channels so that financial capital can flow to productive enterprises that increase the general welfare.

As we step forward into 2021, we’re going to adopt a more expansive view of this problem.

The approach is two-pronged: expanding the market for our existing services; and creating a separate business that can address our mission at scale.

* * *

Expanding the market for our existing services

Though we will still serve long-term investors and entrepreneurs in emerging and frontier markets, we will target two additional “markets” where capital is relatively scarce:

  1. Science — I discussed the gamification of U.S. venture capital back in 2019, placing a spotlight on the evaporation of funding for life-sciences innovation.

    Advancements in deep science push humanity forward and enhance well-being.

    Yet, the superabundance of capital chasing software startups is contributing to a “diversity breakdown” in venture investing.

    We’re excited to be starting the year working with Europe- and U.S.-focused VCs investing in leading-edge science.

  2. Enabling infrastructure — We’re targeting opportunities with companies that are addressing the “variety of bottlenecks” mentioned above.

    The priority bottlenecks are currency risk management, liquidity solutions / secondaries, and pipeline development.

* * *

Creating a separate business

It is manifest that a new model is needed for providing risk capital to entrepreneurs, particularly — but not exclusively — across Africa, Asia, and Latin America.

Businesses need long-term, equity / equity-like financing.

Investors want faster liquidity.

And legacy capital market solutions have proven inadequate to the challenge.

I think an answer lies in crypto and the tokenization of assets.

Look. There’s a lot of nonsense in the crypto space, and many of its boosters are delusional, petulant children.

Be that as it may, crypto offers a refreshingly open design space that could enable new configurations of economic exchange.

I’m still in learning mode and am wrestling with new ideas and business models. 

But I think crypto has the potential to distribute wealth creation and capture more broadly than our current system.

And that is needed urgently.

Stay tuned!

Alla prossima,
Mike


Jake Cusack on Frontier & Fragile Markets

In the latest episode of the Portico Podcast, I interview Jake Cusack, co-founder and Managing Partner of The CrossBoundary Group — a firm that unlocks private capital for sustainable growth and strong returns in underserved markets.

I first reached out to Jake ~10 years ago, after he and one of his co-founders published a study on entrepreneurship and private sector development in Afghanistan

That initial contact kicked off a series of conversations on how to harness markets and mobilize private capital to build businesses in frontier and fragile markets — the overarching topic of this episode.

Jake and I discuss:

  • His journey from the Marine Corps to founding CrossBoundary;
  • The critical role that investment facilitation plays in creating investable pipeline;
  • The rationale for CrossBoundary’s expansion from an advisory firm to a group that also manages investments;
  • The suitability of the traditional private equity model in frontier markets;
  • Recruitment, and how to inculcate a shared culture across a globally dispersed footprint;
  • CrossBoundary’s recent initiative to open source its approach to project financing mini-grids;
  • And much, much more.

 Check it out on: Apple Podcasts  |  Google Podcasts  |  Spotify


Grab Bag


From the Bookshelf

For this is your home, my friend, do not be driven from it; great men have done great things here, and will again, and we can make America what America must become.

 — James Baldwin, The Fire Next Time (Vintage: 1993)

# # #

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 Decade of Digital Assets

Like many small businesses, Portico had a difficult year.

(It didn’t start off with the best of outlooks, tbh).

Covid shifted project timetables several months to the right, and it materially impacted our clients’ fundraising plans. Some projects we were working on just died on the vine.

As a result, Portico went ~6 months without a penny of cash flow, and some projects we invested scores of hours of energy in delivered $0 to the income statement.

We didn’t take out a PPP loan and dissaved from the company coffers. I think that was the right decision, but it leaves less room for maneuver and new initiatives.

One benefit of this stress test of the business was the affirmation of the need to pivot.

I’ve been testing market demand for a business in the secondary space, but a scalable business model for it remains elusive.

(Last year’s idea fell flat, even though 2020 has been a SPAC bonanza).

Candidly, I’ve been too focused on finding an incremental solution to a problem in a shrinking market, as opposed to starting from first principles and generating a novel idea in a growing market.

The upside is I’ve rectified this recently and unlocked an exciting idea that brings me energy.

One successful initiative for the year was the launch of the Portico Podcast (more below the fold). It’s been a fun experience so far, and I’ve received enthusiastic feedback, which has been nice. 

* * *

So, what next?

A few predictions for the decade ahead …

1. The Decade of Digital Assets

We are in the very early stages of migrating toward an entirely new internet — one that is open, decentralized, and contains extraordinary possibilities for the reconfiguration and exchange of value.

I mentioned Otis last year, but another example you may want to look at is the NBA’s Top Shot — an officially licensed marketplace that enables individuals to own highlight reels of their favorite players. It’s like trading baseball cards but with a globally active secondary market for cards and live transaction comps for pricing. Each asset’s fidelity, scarcity, and ownership are verified through registration on the blockchain.

There’s also bitcoin. I wrote about cryptocurrencies vs. the U.S. dollar last year. But now Morgan Stanley’s Ruchir Sharma has joined the fray. I think institutional adoption of bitcoin will happen at scale over the next 10 years. (Disclosure: long BTC).

These are just a few examples, but the digitization of assets is going to be enormous.

 * * *

2. Single-Asset, GP-led Secondaries

There is a crisis of illiquidity in EM private markets. 

I’ve been digging into this as part of my research into a scalable business model in the secondaries space, and I estimate that there are ~1,200 PE and VC fund managers sitting on ~7,000 un-exited investments across EM.

(These figures are for funds with vintage years 2008-14).

Distributions from EM funds have been poor, and they’ve undershot the global PE benchmark every year (see below).

There is a clear problem here that GP-led secondaries can help solve: identifying sub-scale assets that — once liberated from the confines of the PE fund model — can pursue long-term growth initiatives with a reasonable return profile.

With a different shareholder base and investment structure, companies can pursue a broader range of growth strategies, and investors’ returns may be less contingent on a liquidity event.

I think we’ll see more EM GPs use these vehicles in the decade ahead.

But, if you’re interested in EM direct secondaries in general, I’ve been doing research in this space and may be able to help you out.

Click here to send me a note.

* * *

3. New Financing Structures

DFIs are distancing themselves from the traditional fund model as a means for non-bank financial intermediation in EM. This is unfortunate for smaller fund managers that depend on DFI capital to get / stay in business, but it is what it is.

I’m cautiously optimistic that this will create space for new, creative forms of financing for un- and under-banked enterprises.

As one example, the team at CrossBoundary Group has open sourced their project financing model for mini-grids, and I think this collaborative approach to generating shared prosperity is a glimpse of the future.

 * * *

Most of us have been trapped inside and deprived of foreign travel for a calendar year.

I am very much looking for the explosion of energy and excitement that people will exhibit once this pandemic is behind us.

Until then, I have a gift for you.

Please don your favorite set of noise-cancelling headphones and prepare to immerse yourself in 4 minutes and 30 seconds of transcendent bliss. 

Don’t multitask.

Set a timer if you must.

Just click this link to escape to the Cañon del Sumidero in Chiapas, Mexico.

Glimpse majestic natural beauty. Listen to a magical tune. Ponder the possibilities of human ingenuity and creativity.

Health, wealth, and happiness to you and yours.

Abrazos,
Mike


Weijian Shan on Leverage and Turnarounds in Asia

In the latest episode of the Portico Podcast, I interviewed Weijian Shan, the Chairman and CEO of PAG — a leading Asia-focused alternative assets firm with ~$40B in AUM. 

It was a real honor to have Shan on the podcast, as his life story is remarkable.

If you haven’t read his memoir Out of the Gobi yet, I heartily encourage you to do so. It’s an extraordinary book that recounts Shan’s experiences during the Cultural Revolution — particularly the six years he spent doing hard labor in a re-education camp — and the transformative impact that the normalization of U.S.-China relations and Deng Xiaoping’s economic reformshad on China generally, and on Shan in particular.

And he’s just written a new book called Money Games, which details the rescue of one of Korea’s largest banks on the heels of the Asian Financial Crisis.

In addition to his books, Shan and I discuss the importance of stakeholder analysis when structuring private equity investments; whether there is a problem of too much debt in the Chinese economy; SOE reform, and the prospects for China’s economic rebalancing toward domestic consumption; the institutionalization of private equity in Asia; and, his advice for younger people who wish to pursue a career in private equity, among other topics.

If you need to catch up on past episodes on your new device over the holidays, we’ve got you covered:


Grab Bag

  • Has persistence persisted in private equity? Evidence from buyout and venture capital funds (link)
     
  • Do private equity investors create value? Evidence from the hotel industry (link)
     
  • The failure of the standard model of institutional investment (link)
     
  • Special deals from special investors: the rise of state-connected private owners in China (link)
     
  • Ben Thompson on Stripe and financial infrastructure (link)
     
  • France broadens retail investor access to private equity (link)
     
  • RBI toying with idea to allow industrial houses into banking (link)
     
  • Are venture capitalists deforming capitalism? (link)

From the Bookshelf

This age of globalization has made it easy to imagine that the decades ahead will bring more convergence and more sameness. Even our everyday language suggests we believe in a kind of technological end of history: the division of the world into the so-called developed and developing nations implies that the “developed” world has already achieved the achievable, and that poorer nations just need to catch up. But I don’t think that’s true. My own answer to the contrarian question is that most people think the future of the world will be defined by globalization, but the truth is that technology matters more.

— Peter Thiel, Zero to One (Currency: 2014)

# # #

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 2020, 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

⎯⎯⎯

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!

⎯⎯⎯

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!

⎯⎯⎯

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!

⎯⎯⎯

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

⎯⎯⎯

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.