An Extractive Industry

I remember it like it was yesterday.

30 years ago, my father — God rest his soul — dragged me to the hardware store, with the promise that yet another of my boyhood weekends would be spent “building character.”

But this weekend was different.

Instead of heading home after securing the lumber and dirt, we stopped by a Toys “R” Us.

Dad told me to look around while he spoke with a manager, and when I sauntered back to the front of the store, the manager was retrieving — ever so delicately — a Nintendo Entertainment System from a locked display case. My Dad’s outstretched hands rose to the ceiling, as if offering a prayer, ready to catch the box should the manager tumble from the ladder.

Nintendo. Humankind’s third-greatest invention (after the wheel and the Gutenberg press).

That trip to Toys “R” Us was one of the most joyful moments of my childhood. I am certain that I am not alone — Toys “R” Us was an iconic company that enriched the lives of millions of children.

And private equity destroyed it.

Let’s not mince words: leveraged buyouts (LBOs) constitute an extractive industry.

In the case of Toys “R” Us, Bain Capital, KKR, and Vornado took the company private in a $6.6B LBO in 2005. It is now bankrupt and closing all of its stores — without paying employees any severance.

In the year of the acquisition, the company generated $11.2B in annual sales, and the linked article says their biggest competitors at the time were the discount retailers Wal-Mart and Target. (Amazon’s shares were ~$35, fwiw).

Revenue was never a problem. Net sales never dipped below $11.3B (in fact they exceeded $13B between 2007-13). However, according to SEC filings, Toys “R” Us’s debt burden jumped from $1.86B at acquisition to $5.5B in the fiscal year after the deal, and annual interest expense climbed from $130m in the year of the acquisition to $400m+ beginning in 2006 (see charts). Optimizing capital structures for whom, one might ask.

ToysRUs2

The LBO firms were on the take from the get-go. According to SEC filings, “upon consummation of the Merger, [Toys “R” Us] paid the Sponsors a fee in the aggregate amount of $81 million for services rendered and out-of-pocket expenses.”

In addition, SEC filings show that between 2005-17, Toys “R” Us paid out aggregate “Sponsor management and advisory fees” of $204m. An analysis in The Atlantic suggests there may have been $128m in (incremental?) transaction fees as the company bought up KB Toys (another Bain Capital bankruptcy special) and other toy retailers.

Consider that between 2014-16, when Toys “R” Us was posting losses of $867m, $256m, and $48m, the company paid out advisory fees of $22m, $18m, and $6m. In other words, in the three years that the private equity sponsors were overseeing losses before taxes of nearly $1.2B, they still drew fees of $46m.

That giant sucking sound you hear is LBO firms hoovering out the value from a cash-generating company. One that likely could have remained a going concern, had the LBO firms not forced down such an onerous debt burden.

Again, 30,000 employees were fired without receiving severance. This is Dickensian villainy at its finest. It evokes The Ghost of Tom Joad.

The FT reports that some of KKR’s pension fund clients “are re-examining their relationship with the investment group amid anger over the treatment of workers at the bankrupt retailer.” They should.

But they shouldn’t stop there — they should re-evaluate their investments in LBOs altogether.

Here’s the dirty little secret: when pensions invest in LBO funds, they are fueling inequality.

The entire LBO model is predicated on bogging down cash-generating businesses with debt, and compelling managements’ hands to create efficiency gains (i.e., layoffs). In other words, thousands of people must lose their jobs and benefits, and be plunged into a state of precarity, in order for pensioners to remain secure in their stipends. It is absolutely zero-sum.

One of the most rigorous takedowns of the LBO model is Eileen Applebaum and Rosemary Batt’s Private at Equity Work. I highly recommend it.

Notably, one of their conclusions is that, unlike LBOs, private equity investments in small and midsize companies can drive meaningful business growth and innovation. I — and others — would argue that the opportunities for shared value creation are even greater in emerging and frontier markets.

When I came up with Portico’s ethos, I jotted down the following:

Value creation > value extraction
Build something that increases the general welfare. While there are riches to be made in value extraction, we do not believe in doing well at the expense of others. Spread dignity.

The fate of Toys “R” Us is precisely the type of BS I had in mind when I wrote those lines.

I would encourage all investors to consider the long-term consequences of the LBO model, and to eschew such extractive forms of investment.

Alla prossima,
Mike

P.S. The newsletter is taking a hiatus in August. See you in September.

Raising a Fund

At Portico, we believe in fund managers who are trying to build businesses and increase prosperity across the world.

In a sense, Portico was founded as an anti-gatekeeper. We believe that too many service providers in this industry operate in a black box, and that this lack of transparency ultimately hurts everyone.

With that in mind, we created the Informal Guide to Raising Your First Fund. Our goal with this product is to empower fund managers with the knowledge they need to develop an institutional-quality pitchbook. We’ve bundled it with a 27-page sample pitchbook to maximize its practical utility, and the feedback we’ve received tells us it’s equally relevant for managers raising funds III, IV, and beyond.

Given the exceedingly difficult fundraising environment, we’re pleased to announce that we are now offering it for only $149. It’s more important to us that a greater number of firms succeed — and that the industry develop — than that we sit on useful knowledge.

Invest in yourself. As our next story demonstrates, it’s only going to get tougher for EM managers to raise capital.

Abraaj: Redux

(For background, read parts III, and III)

This is way bigger an exposure than anyone expected … What is shocking is that the company invested almost 10 percent of its total assets and all their investment book with one company.

I am surprised that the company had more than 70 percent of its 1.5 billion-dirham investment portfolio exposed to a single fund and this was never flagged by the auditors or questioned by the shareholders.

These two quotes come from a Bloomberg article on Air Arabia’s disclosure that it faces a $336m exposure to funds managed by Abraaj.

That is a lot of granola. But it’s only part of the story.

Abraaj executed a pre-IPO investment in Air Arabia in 2007, and it secured two board seats in the process. Arif Naqvi retained his position on the board through 2017 (though he didn’t show up to the first three meetings in 2017).

Somehow, nobody seemed to see a conflict of interest in Air Arabia directing “all their investment book” to a board member’s firm?

It gets worse. The Wall Street Journal reports that, “Money originating from Air Arabia was used to replenish the [Abraaj Growth Markets Health Fund], according to people familiar with the situation. KPMG’s review of the fund didn’t mention this, one of those people said.”

KPMG, you may recall, was the firm Abraaj selected to examine the books of its healthcare fund after this whole imbroglio erupted in the press. KPMG is also the auditor of Air Arabia (among other Abraaj portfolio companies).

And then there’s the bombshell.

A separate Wall Street Journal article reveals that PricewaterhouseCoopers, a provisional liquidator for Abraaj Holdings, “have ‘been unable to obtain standalone annual financial statements or management accounts’ for the holding company, a situation they described as ‘highly irregular.’”

Absolutely extraordinary. It’s a sentence worth reading again.

According to the Journal, the PwC report goes on to say:

This lack of financial record-keeping raises the question of how the company’s directors were able to ensure the company was solvent and being effectively managed.

Investment management fees revenue had, for some years, been insufficient to meet its operating costs.

Any liquidity shortfall was largely funded through new borrowings.

Reuters reporting adds that “Abraaj’s total debt stood at $1.07 billion … including $501.4 million in unsecured debt and $572.4 million [in] secured debt.”

The launch of the $6B mega-fund may be viewed in a new light.

The whole situation stinks.

And the stink is on many hands.

Who was doing due diligence? With what documents? Where was the fund administrator?

Institutions were throwing money at Abraaj. Washington State Investment Board, for example, unanimously approved an investment of up to $250m, plus fees and expenses, in the mega-fund, “based on Abraaj’s solid overall investment performance, large, institutionalized team … [and] a consistent investment and risk underwriting process applied globally.”

During the preceding Private Markets Committee meeting, Hamilton Lane “discussed [Abraaj’s] approach to investing, reputation, culture, track record, and currency risk” and supported the staff’s recommendation to invest in the fund.

They’re not the only ones. It’s just that their minutes are public.

Consider, for example, the long list of third parties that provided Abraaj the equivalent of a Good Housekeeping Seal of approval:

  • Abraaj reportedly received its third A+ rating from the UN Principles for Responsible Investment last year.
  • Arif Naqvi was on the Board of the UN Global Compact and a Founding Commissioner of the Business and Sustainable Development Commission
  • He is also a member of “The B Team” — a self-appointed group of business leaders that seeks to advance ESG, etc. Literally the first challenge on their website is, “Drive full transparency: be open, transparent and free from corruption, with good governance and accountability at all levels of our organizations.”
  • The Harvard Business School and Kennedy School connections.
  • The World Economic Forum.
  • Gatekeepers.
  • Auditors.
  • PR firms and the press.
  • Etc.

If there is one lesson from this fiasco, it is that it pays to do your own work.

Also, don’t chase shiny objects.

Fin.

P.S. As we suggested in March, it appears that LPs in the Africa fund are looking for a new GP to manage out the assets.

Small Is Beautiful in CEE

EMPEA recently released a report on private markets in CEE and it’s really quite good. My fundamental takeaway from the report is that the region attracts little capital — between $500m and $1.5B annually between 2009-17 — but this lack of capital is why (a handful of) investors like it.

Consider that, according to the PitchBook data in the study, the median Eastern European buyout multiple between 2006-17 was 5.8x — the lowest multiple globally.

Admittedly, there were few transactions that provided data points for PitchBook, so let’s look at the other end of the spectrum: as of December 2016, EBRD’s portfolio of CEE funds — which is, like, every CEE fund ever — has delivered roughly 7.5% net across all vintages. It’s not an exceptional number, but private equity’s not about investing in an index.

Moreover, it’s not like pension funds — which aren’t pursuing EBRD’s development mandate — are doing much better. According to the American Investment Council’s 2018 Public Pension Study, the median U.S. pension fund’s private equity portfolio delivered a 10-year annualized net return of 8.6%.

Anyway, as I read the briefing, I reflected upon Portico’s thought piece from last December — Does EM PE Scale? — and decided that what’s happening in CEE is a beautiful outcome. The GPs and LPs interviewed for EMPEA’s piece seemed happy with the status quo: most investors have mistaken perceptions of the region’s risks, so they don’t invest in it; and those LPs that do invest in the region have found manager relationships they value across cycles.

Maybe EM PE is an artisanal industry.

Insomnolent in India

Bain & Co. released the 2018 edition of their India Private Equity Report. Lots of charts. Lots of things moving up and to the right.

Bain asked respondents to its survey, “What keeps you awake at night?”

The top three responses:

  • Mismatch in valuation expectations (~75% of respondents)
  • Challenges to maintain high level of returns (~55% of respondents)
  • Lack of attractive deal opportunities (~50% of respondents)

Those seem like … the core elements of running a PE business? No wonder so many Indian GPs are happy to take my calls at 2am IST — they’re not sleeping!

Funnily enough, respondents were least concerned about, “Approaching end of fund life with unliquidated assets” (~3% of respondents).

Now, Bain’s survey had 39 respondents out of a universe of active investors they estimate at 491. But I wonder, would the percentage be much different if the sample size quadrupled?

Zombie4

Turkey: Value Trap?

Last November, we asked if Turkven’s Seymur Tari was precipitating a market turn in Turkey. After seven years of declining business and consumer confidence, was the country on the cusp of a resurgence?

Well. After the latest round of elections, the president’s appointment of his son-in-law as the head of the country’s treasury and finance ministry, and changes to the rules for appointing the central bank governor, one wonders if all those assets trading at a discount might constitute a value trap.

The IMF forecasts gross external financing requirements of ~25% of GDP (equal to ~$200B) each year through 2023.

Turkey’s policymakers confront a delicate dance, indeed.

From the Bookshelf

There is a crime here that goes beyond denunciation. There is a sorrow here that weeping cannot symbolize. There is a failure here that topples all our success. The fertile earth, the straight tree rows, the sturdy trunks, and the ripe fruit. And children dying of pellagra must die because a profit cannot be taken from an orange. And coroners must fill in the certificate — died of malnutrition — because the food must rot, must be forced to rot.

The people come with nets to fish for potatoes in the river, and the guards hold them back; they come in rattling cars to get the dumped oranges, but the kerosene is sprayed. And they stand still and watch the potatoes float by, listen to the screaming pigs being killed in a ditch and covered with quick-lime, watch the mountains of oranges slop down to a putrefying ooze; and in the eyes of the people there is the failure; and in the eyes of the hungry there is a growing wrath. In the souls of the people the grapes of wrath are filling and growing heavy, growing heavy for the vintage.

— John Steinbeck, The Grapes of Wrath (Bantam Books: 1970)

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

 

Transparency & Governance

I’ve been meditating on transparency and governance rather frequently of late. Not out of a sense of righteousness, mind you, but largely because they are inescapable in my morning reading of the newspaper: Abraaj, Norway (both discussed below), FacebookMartin SorrellSean Hannity, &c.

The only firm conclusion I’ve reached is that quality governance — corporate or otherwise — is the most underappreciated necessity. A world awash in capital is also a world awash in unaccountable bullshit. People just don’t seem keen to ask — let alone field — questions when the money’s rolling in. Plus ça change …

Say what you will about younger generations, but they’re pretty quick to raise the BS flag and ask uncomfortable questions (so much so that it has become a meme, apparently). I was reminded of this recently while giving a guest lecture at UVA’s McIntire School of Commerce. The students were super sharp, and they asked hard-hitting questions … including one that made me ponder some life choices.

In short, they’re awesome. They rekindled my belief that the future is going to be amazing. Hopefully their incessant questioning will continue as they assume positions of leadership, thus contributing to more transparent and accountable governance. On verra bien …

Speaking of the future, Portico’s first product launch is in the works. We’re making it easier than ever for first- (and second-, and third-, &c.) time funds to produce institutional-quality marketing materials, at a price point that delivers enormous value. Stay tuned!

Finally, I’m really looking forward to IFC’s Global Private Equity Conference next month (hosted in association with EMPEA). It’s the 20th anniversary of the event and it should be a good one. I’m excited to reconnect with friends and make new connections. Drop me a line if you’re planning to attend.

If you haven’t registered, you may learn more about the event at this link. Hope to see you there!

Alla prossima,
Mike

GPEC Banner

Abraaj: Fin?

[This is the third — and final — in a series; see Part I and Part Deux]

“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.”

So read the conclusion to my take on the drama at Abraaj in last month’s newsletter.

I don’t know whether the investors drove the process, but Houlihan Lokey was brought in to find a solution to the Abraaj Growth Markets Health Fund debacle, and the FT reports that Abraaj subsequently offered to step down as manager of the fund. An interim manager is reportedly in the cards until a permanent replacement / solution is found.

A few thoughts / observations:

  • Key Person Provisions — More senior departures were reported over the last month, including those of Sev Vettivetpillai and Mustafa Abdel-Wadood, both of whom reportedly attempted to resign late last year but were asked to stay. The Wall Street Journal reports that “the firm now has lost half its managing partners and a third of its partners in the past year.” At this point, given the flood of senior departures, it stands to reason that Key Person termination provisions likely have been triggered across several Abraaj funds. If so, then I imagine investors will be looking for (a) new GP(s) to manage out the assets.
  • Sharks Circling — The firm is reportedly considering a sale of its private equity business to raise cash, and reducing headcount by 15% to cut costs. It is also moving forward with its planned listing of the South African FMCG company Libstar.
    Kenyan sources report that the firm is evaluating a sale of its stake in Nairobi Java House, which it acquired from ECP last year. (I talked about the deal here). The same article reports that sales of Avenue Hospital, Brookside Dairies, and Seven Seas Technologies may be under consideration as well. With all these headlines, management teams and fund managers may be sensing an opportune moment to scoop up shares at a discount from a stressed seller.
  • Exit Closed — In recent years, Abraaj had become an active buyer of PE-backed companies, particularly in Africa (e.g., Java House, Libstar, Mouka). Had its $6 billion mega fund come to market, I imagine Abraaj would have become a sought-after exit channel for GPs. In a way, it could have become to EM private markets what the SoftBank Vision Fund is to venture investors: a deus ex machina of liquidity.
  • &c. — Its portfolio company Stanford Marine has reportedly breached covenants and is seeking to restructure $325 million in debt. Reuters reports that it is seeking repayment of $12.4 million in loans to Nigeria’s C&I Leasing. Deloitte has been called in to look into its governance and control issues. &c.

I’m tired of writing about Abraaj. I don’t plan on including anything about the firm in next month’s newsletter.

The news articles are likely to keep coming, though, and the developments over the last month suggest that it will take a long time to clean up the detritus from this unfortunate turn of events. Here’s hoping that it doesn’t contribute to investors’ exodus from EM private markets altogether.

Norway: Part Deux

In January’s newsletter, we mentioned that Norway’s sovereign wealth fund had submitted a recommendation to the finance ministry that it be allowed to invest in and alongside private equity funds. At the time, we held out a grandiose vision of a world in which the fund might build a genuinely differentiated approach to EM private markets.

Well, the finance ministry has issued its report, and fund managers’ hopes for a veritable tsunami of cash have been put on hold.

Indefinitely.

The preliminary, unofficial translation of the report provided a fairly damning assessment of the asset class’s fees and opacity:

Low costs are characteristic of the GPFG. External equity management costs in the listed market are about 0.5 percent … measured relative to assets under management. In comparison, the annual cost of investing in private equity funds can be estimated at about 6 percent of assets under management …

Transparency is an important prerequisite for broad support for, and confidence in, the management of the GPFG. Many private equity funds disclose little information about their activities …

High prospective returns aren’t a sufficient argument for new money to come into the asset class — especially when its citizens’ savings. We’ve said it before and we’ll say it again: the industry will not thrive without trust, transparency, and quality corporate governance.

Bain & Co.

Two findings jumped out at me from Bain & Co.’s Global Private Equity Report 2018:

  1. Entry pricing is … inauspicious.As of year-end 2016, the percentage of deals priced at <7x EBITDA (~10%) was the lowest it had been since at least 2007, while 54% of deals were done for >11x EBITDA (compared to ~35% in 2007). “Our presumption is that we’ll be exiting at smaller multiples,” says Alan Jones of Morgan Stanley Global Private Equity. Agree
  2. Long-hold funds can outperform. Bain ran an analysis comparing a theoretical long-hold fund selling an investment after 24 years against a buyout fund selling four successive companies over the same period. Their finding: “By eliminating transaction fees, deferring capital gains taxation and keeping capital fully invested, the long-hold fund outperforms the short-duration fund by almost two times on an after-tax basis.” [emphasis added]

At Portico, we’re privileged to work with firms that are pursuing non-traditional and longer hold strategies. We think it’s only a matter of time before more investors come to see the benefits of these approaches.

Grab Bag

  • Into Africa—The FT reports that the EBRD is considering an expansion into Sub-Saharan Africa. The politics of getting this approved might be tricky, but EBRD could do a lot of good on the continent. 🤞
  • India — IFC’s Ralph Keitel gives a masterclass on PE in India in this interview.
  • Management Fees— Dave Richards of Capria has an interesting view on how GPs should be determining their management fees. Hint: they should be predictable and budgeted, rather than a percentage of committed / invested capital.
  • Theranos— “It has been pretty obvious for a few years now that Theranos Inc. was a huge fraud.” Matt Levine’s take on the Blood Unicorn, Elasmotherium haimatos. And, its solicitation for cash after its CEO settled fraud charges?

From the Bookshelf

Make friends with those who are good and true, not those who are bad and false.

— Eknath Easwaran (trans.), The Dhammapada (Nilgiri Press: 2007).

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

The White Stripe

A small print of Jody Clark’s “Keep Treading” hangs on a wall in my office. It’s a picture that I first saw at the Brazilian Jiu Jitsu (“BJJ”) gym where I started training last fall. It shows a man in a gi trying to stay afloat in the ocean. An eel is wrapping around his legs and pulling him asunder, while a collection of sea nettles threatens to sting him if he reaches out his arms.

It’s an apt metaphor for the travails of a white belt in BJJ. As Sam Harris describes it, “The experience … is akin to falling into deep water without knowing how to swim. You will make a furious effort to stay afloat—and you will fail.”

That is an accurate one-word summation of my first five months in BJJ: failure. Relentless, unmitigated failure. Soul- and ego-crushing failure.

Consider this dispatch from my BJJ journal:

2/10 – Open Mat

Performed poorly. Got smashed. Decent defense but too passive. Need to be more aggressive. Neck got crushed while in turtle. Honestly I just feel dejected.

There are days when the hardest thing is showing up to class or open mat. The certainty of being smashed, submitted, and in pain makes it all seem like a futile exercise. It’s so tempting to quit in the face of near-certain failure.

But, you have to keep treading. It’s all a bit of a metaphor for life as a whole.

Last week, I received my first stripe on my white belt. I know it’s foolish to place much stock in outward signs of progress, but this promotion—this piece of tape—was one of the more hard-earned accomplishments in my life. And yet, it’s merely the first rung on the ladder. Progress. One aching, small step at a time.

In other news, I’m looking forward to joining some folks from General Atlantic next month for a conversation with students at UVA’s McIntire School of Commerce. Should be fun!

I’ve also created a video of the presentation that I delivered at the UNC Alternative Investments Conference last week (some of the slides are featured below). If you’re keen to see a 30-minute overview of EM PE, check it out on YouTube!

Alla prossima,
Mike

Abraaj: Part Deux

In last month’s newsletter we discussed the drama at Abraaj following revelations that four LPs had hired forensic accountants to probe the books of the Abraaj Growth Markets Health Fund.

The situation is serious, indeed:

  • Abraaj’s fund management business is being split off into a separate entity with an independent board “to which internal audit and compliance will directly report.”
  • Abraaj’s founder, Arif Naqvi, relinquished management of the funds business, though he is expected to serve on its investment committee.
  • The firm announced a halt to investment activities.
  • Private Equity News reports that Themis, the energy team that Abraaj acquired in March 2016, sought to end its partnership with the firm as early as mid-2017. Denham Capital announced a new platform agreement with Themis earlier this month.
  • The WSJ reports that the firm is weighing job cuts as its fundraising is put on hold; existing investors in its $6B target mega fund are asking for their money back; investors in other funds are considering selling their stakes; and, lenders are reviewing credit lines for their capital call facilities.
  • The FT reports that the firm’s CFO departed.

Meanwhile, the firm is still unable to secure an exit from K-Electric, a divestiture it announced in October 2016. Abraaj was slated to receive a consideration of $1.77B from Shanghai Electric Power, a subsidiary of the State Power Investment Corporation of China; however, the transaction has been dogged by delays.

According to a local news report dated 9 March, the Pakistani government still had not cleared the sale, in part because it has not received a copy of the sale-purchase agreement, in part on national security grounds, and in part because the company is alleged to owe “dues” upwards of PKR139 billion (~$1.25B). Arif Naqvi is reported to have met with government ministers this week in an attempt to accelerate the sale.

What a mess. I’m left wondering if investors in the firm’s funds will seek (a) new GP(s) to manage out the assets.

EM Fundraising: Coming Full Circle?

 

giphy2

“Coming Full Circle.” So reads the adulatory headline from EMPEA’s year-end 2017 statistics, which show $61 billion in EM fundraising across PE, private credit, and infrastructure and real assets—the highest level since 2008. Break out the champagne glasses and lace up those dancing shoes. EM PE is back!

Or not.

Looking at fundraising for buyout and growth equity funds, the volumes remain stagnant since 2011 (see below). Though 2017 shows a rebound, the aggregate figure is deceptive: KKR Asia III clocked in at $9.3B and Affinity Asia closed on $6B, which means these two funds account for 40% of the capital raised for buyout and growth strategies. That leaves about $20B for the rest of EM. It’s peanuts!

FRchartv2

The trends we highlighted in November 2016 are continuing apace, with only 75 growth equity funds achieving a close in 2017—a 44% decline since 2010. In addition, new entrants are struggling to get traction. EMPEA’s own analyses show that first-time growth equity funds have declined from 30% of the capital raised for the strategy in 2008-09 to less than 10% over the last four years.

At issue is a lack of distributions and a lost decade for LPs in EM buyout and growth equity funds (see below). There is a sharp drop-off in distributions beginning in 2007 / 08 when fundraising exploded. It’s a decade later, and the breakpoint for top-quartile funds beginning in 2008 hasn’t returned investors’ capital.

lostdecade

These performance indicators from Cambridge Associates are damning, and it’s no surprise why LPs have been walking away from “traditional” EM PE in greater numbers.

But there’s something about this exhibit that bothers me. I know many established managers that refuse to provide their performance figures to Cambridge. One global manager was befuddled when I presented these figures; s/he noted that their EM deals generated IRRs well north of 30%.

It’s worth asking whether Cambridge’s benchmarks are a worthy benchmark in EM. I have my doubts.

For example, a quick sketch comparing the universe of EM buyout and growth equity funds—as collected by EMPEA—to those in Cambridge Associates’ database show that CA has between 4% and 21% of the total number of funds by count, and between 29% and 60% by total capitalization (excluding 2011; see below).

cambridge

The industry is poorly served by these benchmarks. I should probably stop using them, but there is no credible alternative.

If only there were an organization that could serve as a utility for the industry—one that provided impartial data on private capital performance … 🤔

In any event, as bearish as I’ve been about the prospects for the EM PE industry, I am cautiously optimistic that we’re close to reaching a bottom. If flows to EM public equities continue, then the exit windows should stay open, managers should distribute cash to their LPs, and then capital can be recycled to new commitments.

While I don’t expect EM-dedicated growth equity and buyout funds to come “full circle” to the $58 billion they raised in 2007 anytime soon, the scarcity of capital allocated to the sub-$1 billion segment portends well for the performance of current vintages. And if history is any guide, LPs will herd back into these markets after the “easy” money has been made.

giphy1

Private Equity: Overvalued and Overrated?

Dan Rasmussen of Verdad is not making friends with many people in private equity. His former colleagues at Bain Capital must wish he’d stop talking. Like him or hate him, Dan puts out thought-provoking, empirically driven takes on the myths and realities of U.S. buyouts (see last December’s newsletter for an example).

In his latest piece, “Private Equity Overvalued and Overrated?”, Dan probes three premises about which there is “near-complete consensus:”

  • PE firms make money by creating value in portfolio companies;
  • PE is less volatile / risky than public equity; and,
  • PE will significantly outperform other investments.

Rasmussen’s most interesting conclusion pertains to the first bullet: the myth of value creation. Verdad constructed a database of 390 deals—representing more than $700 billion in enterprise value—for which the PE firm issued debt to finance the acquisition. This enabled Verdad to compare underlying companies’ financial performance both pre- and post-acquisition. What did they find?

In 54 percent of the transactions we examined, revenue growth slowed. In 45 percent, margins contracted. And in 55 percent, capex spending as a percentage of sales declined. Most private equity firms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth.

If PE firms are not growing businesses faster, investing more in growth, or gaining much operational efficiency, just what are they doing?

In 70 percent of cases, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet, from 2.5x EBITDA to 5x EBITDA—the biggest financial change apparent from our study.

With $1.7 trillion in dry powder, rising rates, and average U.S. LBO entry multiples hitting 11.2x EBITDA, this just does not seem like an attractive value proposition.

Persistence in Private Equity

McKinsey’s Global Private Markets Review has a fascinating finding on the decline of persistence in private equity performance. Notably, “follow-on performance is converging towards the 25 percent mark—that is, random distribution.”

At a time when capital is flooding to mega-cap funds and, at least in emerging markets, established GPs with a track record, I wonder whether new techniques are needed for manager selection. Perhaps the winning LPs will be those with the liberty to chase a variant perception of value; those less hamstrung by rigid asset allocation buckets and / or institutional constraints.

Je ne sais pas.

From the Bookshelf

A man is born gentle and weak.
At his death he is hard and stiff.
Green plants are tender and filled with sap.
At their death they are withered and dry.

Therefore the stiff and unbending is the disciple of death.
The gentle and yielding is the disciple of life.

Thus an army without flexibility never wins a battle.
A tree that is unbending is easily broken.

The hard and strong will fall.
The soft and weak will overcome.

— Lao Tsu, Tao Te Ching (Vintage: 1989).

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

Veritas

Last month, the New York Times published a fascinating article about the market for followers on Twitter. (Disclosure: shareholder of NYT and TWTR). The manufacture of social capital is something that I hadn’t really thought about before, but now that my eyes have been opened, it’s hard not to notice it.

For example, it’s always been nauseating when someone namedrops to inflate his or her reputation, but I hadn’t considered companies leveraging the brand equity of established firms to magnify their own. Think of all the conferences and august fora where firms’ logos are on display. (Yours, too, could be featured amongst the great and the good for a modest sum).

Or, consider this: have you ever read a profile of a firm or entrepreneur and, en passant, your nose turned up in a visceral reaction? Something just smelled about it? Me too. The article was probably placed. By a PR firm that doesn’t do nuance. Occasionally, these articles include character references from individuals who are compensated by the company being profiled, and yet the credulous journalist didn’t care to ask about potential conflicts.

The currency of currency is all a bit exhausting. I’m reminded of Diogenes the Cynic’s apocryphal confrontation with Plato:

On seeing [Diogenes] washing vegetables, Plato came up to him and quietly remarked, “If you paid court to Dionysius, you wouldn’t need to be washing vegetables,” to which he replied in the same calm tone, “Yes, and if you washed vegetables, you wouldn’t need to be paying court to Dionysius.”

Anyway. Next month, I’ll be at the UNC Alternative Investments Conference, where I will be leading a teach-in session on the role of EM PE in LPs’ portfolios. I’m planning to cover the evolution of emerging markets and explore whether investors are being presented with a richer landscape of opportunities than was available in the past. I’m really looking forward to it. Click here to learn more about the event, and please reach out if you’re planning to attend.

Alla prossima,
Mike

Abraaj

The New York Times and Wall Street Journal report that the Bill and Melinda Gates Foundation, CDC Group plc, IFC, and PROPARCO have hired forensic accountants to probe the books of the Abraaj Group. The investigation is focused on the use of funds within the $1 billion Abraaj Growth Markets Health Fund.

According to the WSJ, which claims to have reviewed the fund’s quarterly reports to investors, Abraaj called $545 million between October 2016 and April 2017, but had invested $266 million by September 2017. In October 2017, the four LPs are said to have asked for bank statements to show what—if anything—was done with the balance of the funds. Abraaj is said not to have provided them. In December, Abraaj is said to have returned $140 million to the fund’s investors.

A reading of the two articles together suggests that there may be some disagreements over the obligation to return called capital—and the time window for doing so—when projects are delayed rather than canceled. Two hospital projects—one in Karachi and one in Lagos—are said to have been delayed.

The WSJ notes that “construction in Karachi was delayed by a ban on new buildings more than two floors high. The planned hospital had 17 floors.” Local media sources report that the ban went into effect in May 2017 due to water shortages and inadequate civil infrastructure in Karachi. Last month, Pakistan’s Supreme Court approved construction for buildings up to seven-storeys high.

Abraaj released a statement on 4 February saying, “recent media reports … are inaccurate and misleading.” The firm states that it appointed KPMG in January 2018 “to verify all receipts and payments made by the Fund,” and that as of 7 February, “KPMG has now completed its findings and reported that all such payments and receipts have been verified, in line with the agreed upon procedures performed, and that unused capital was returned to investors.”

The forensic accountants’ investigation has either not yet been completed, or the findings have not been disclosed publicly.

To an outsider, this looks quite bad. The investor syndicate that hired the forensic accountants isn’t comprised of neophytes to EM PE and impact investing. On the contrary, they’re the most experienced LPs in the industry. IFC alone has invested in over 200 EM funds over the last decade, while CDC is an active investor in 164 funds in 74 countries—including other Abraaj vehicles. These investors have mainstreamed EM PE as an institutionalized investment strategy. If their concerns are in the newspapers, then it’s worth paying attention.

More broadly, this could have knock-on effects across the broader EM private markets landscape. Integrity and transparency are vital, particularly in an opaque industry and in markets where investors confront information asymmetries. To the extent this story encourages managers to improve their operations and reporting, this is a good thing. However, with one of the largest and most visible EM firms coming under scrutiny regarding its use of funds, there is a risk that more investors will just walk away from EM altogether.

The industry will not thrive without trust, transparency, and quality corporate governance.

Abraaj is currently in the market for a $6 billion mega fund. The WSJ’s sources suggest that the firm has collected $3 billion toward its target. I find that incredible; not only because there have been several senior departures from Abraaj of late, but also because it’s hard for me to make the math work from both a top-down and a bottom-up perspective.

  • From a top-down perspective, we explored the absorptive capacity of EM PE in our latest research piece, which, based on an analysis of exits and M&A volumes, suggests that annual flows to traditional fund strategies may need to shrink to $16 billion per year. Can one firm collect a third of that and invest it well? I have my doubts.
  • From a bottom-up perspective, Abraaj built its global platform through the acquisition of Aureos, an SME-focused investor that was writing $10 million checks. In recent years, Abraaj has been securing deals through auctions—outbidding established large-cap firms such as Carlyle and TPG—and secondary buyouts from the likes of Actis, Advent International, ECP, and Metier. It seems reasonable to ask about pricing pressures and style drift.
  • Finally, the firm has raised an estimated $3B across five funds since 2015 and appears to be in the market for upwards of $7.1B across four funds (see exhibit below). Where are they going to put it all?

Of course, all this may just speak to my failure of imagination.

Several institutional investors have read Hamilton Lane’s reports and clearly disagree with the previous assessments. Washington State Investment Board (approved unanimously, up to $250 million) and Teachers’ Retirement System of Louisiana (approved 6-3, up to $50 million) have committed to the mega fund, while PEI reports that Teacher Retirement System of Texas is on board as well.

Scale has its advantages.

Abraaj2

Private Debt in Africa

Runa Alam of Development Partners International co-authored an intriguing article on the prospects for private debt in Africa. There’s clearly demand for more flexible capital solutions amongst local businesses, and my understanding is that some early suppliers of credit / mezzanine solutions on the continent, such as Amethis and Vantage Capital, have done well. As one would expect given the supply-demand imbalance, new entrants emerged:

  • Helios Investment Partners launched Helios Credit, its direct lending platform, in 2015.
  • Ethos acquired Mezzanine Partners in July 2016 and launched Ethos Mezzanine Partners 3 with a target of $150 million.
  • Syntaxis Capital, a Central and Eastern Europe-focused private debt investor launched an Africa strategy in 2016, establishing a presence in Lagos.

Presumably DPI will be joining them.

It’s important to remember, though, as one seasoned private credit manager once put it to me, “leverage is not your friend in emerging markets.” Private credit is more than just a position in the capital stack. It requires a different skillset than growth equity, and a deep understanding of volatility’s impact on balance sheets and cash flows. Choose your partners wisely.

Taking a step back, it’s great to see a broader set of financing options being made available to entrepreneurs on the continent. For LPs willing to look, there are some very interesting managers with vehicles that expand Africa’s investable market. (Drop us a line if you’d like to know more).

Always Low Prices

Walmart, the world’s largest company by revenue, is reportedly shopping around their Brazilian operations. ACON Investments, Advent International, and GP Investments are said to have been pitched.

According to Thomson Reuters, the company’s 471 local stores generated revenues of $9.4 billion in 2016. However, the company “posted operating losses for seven years in a row after an aggressive, decade-long expansion left it with poor locations, inefficient operations, labor troubles and uncompetitive prices.” In short, apart from the labor troubles, they weren’t Walmart.

Apparently, several retailers took a look at Walmart’s assets in the country, but took a pass on them after concluding the suco ain’t worth the squeeze. A consequence, it seems, of Walmart’s poor customer understanding and a bungled expansion strategy.

It will be interesting to see if a private equity buyer can turn things around, but it’s pretty clear they won’t be paying up for the privilege to do so. In that sense, Walmart’s finally operating true to form: offering bric-a-brac at the deeply discounted prices that shoppers have grown to love.

Currency Risk in Emerging Markets

Sarona Asset Management released the final report of its nearly year-long initiative, “Expanding Institutional Investment into Emerging Markets via Currency Risk Mitigation.”

Sponsored by USAID’s Office of Private Capital and Microenterprise, and in partnership with EMPEA and Crystalus Inc., the initiative sought to develop innovative, practicable solutions to FX risk management in EM PE. The final report contains a wealth of data and information on FX hedging in EM, as well as three new “solution pathways” that the project tested with practitioners:

  • New direct currency hedges (i.e., covertures and supported range forwards);
  • Proxy hedges (i.e., baskets of liquid, low-cost interest rate, equity, and commodity options); and,
  • Insurance.

The proxy hedge was piloted through simulated back tests against two EM PE portfolios over 20 years, and the product shows promise. However, as always with hedging, the devil is in the details.

USAID and Sarona have kindly made the report available to the public. Click here to download it.

From the Bookshelf

Recurrent descent into insanity is not a wholly attractive feature of capitalism …

The only remedy, in fact, is an enhanced skepticism that would resolutely associate too evident optimism with probable foolishness and that would not associate intelligence with the acquisition, the deployment, or, for that matter, the administration of large sums of money. Let the following be one of the unfailing rules by which the individual investor and, needless to say, the pension and other institutional-fund manager are guided: there is the possibility, even the likelihood, of self-approving and extravagantly error-prone behavior on the part of those closely associated with money …

A further rule is that when a mood of excitement pervades a market or surrounds an investment prospect, when there is a claim of a unique opportunity based on special foresight, all sensible people should circle the wagons; it is the time for caution. Perhaps, indeed, there is opportunity … A rich history provides proof, however, that, as often or more often, there is only delusion and self-delusion.

— John Kenneth Galbraith, A Short History of Financial Euphoria (Penguin: 1993).

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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.

Copyright © by Portico Advisers, LLC 2018, all rights reserved.

 

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.