Liquefaction

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

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

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

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

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

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

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

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

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

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

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

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

I have my doubts.

At the very least, confidence intervals should be adjusted.

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

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

It’s time to think different.

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

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

Alla prossima,
Mike

Herd Behavior

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

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

As usual, it’s worse than it appears.

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

Screen Shot 2018-10-24 at 11.36.46 AM

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

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

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

KYC

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

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

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

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

A few quick reactions:

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

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

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

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

Add-Backs

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

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

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

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

Meh, it’s not your money.

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

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

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

Says Institutional Investor:

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

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

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

Every cloud has a silver lining.

¡Salud!

Public Companies and Short-Termism

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

Says the study:

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

You learn something every day.

And who knew R&D was an asset class?

Impact Investing

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

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

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

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

From the Bookshelf

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

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

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

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

 

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.

 

Questions of Leadership

“There is no global EM champion.”

IFC and EMPEA’s Global Private Equity Conference came and went in a blur, but that comment from Nicolas Rohatyn has remained lodged in my brain. There are many ways to read it.

One is to ask: qué? There are global champions that do well in EM. Warburg Pincus comes to mind.

Equally, there are well-known champions within specific markets. A sampling from the BRICs: Pátria in Brazil; Baring Vostok in Russia; Multiples and True North in India; CDH and Hony Capital in China.

Some are less well-known. Some are in other markets. Some are up-and-coming.

Another is to ask if the issue is the lack of a thought leader, like Jim O’Neill (“Mr. BRIC”), who can articulate a fresh vision for the attractions of emerging markets en masse. I’m a fan of Morgan Stanley’s Ruchir Sharma, though he’s a realist not an evangelist. (Maybe that’s why I like him).

Another is to ask if there can ever be a proper EM champion. Can one firm or individual credibly champion all markets at the same time? I think so, but it’s a tough task. Markets across Africa, Asia, Eastern Europe, and Latin America are often at different points in the cycle, with idiosyncratic risks that defy generalization.

Rohatyn’s comment came during a panel titled Global Private Equity Leaders on the State of the Industry. The panelists included a few traditional PE funds (Africa, India, global), but also an energy investor, an Asia credit specialist, and Rohatyn’s firm, an EM hedge fund that acquired a global PE firm (CVCI), as well as EM-focused infrastructure and real estate platforms.

If it’s an uphill battle selling the complexity of EM as a geography meriting investment, is it more so when a discussion with “private equity” leaders includes multiple asset classes?

In any event, if EM private markets are confronting a leadership void — and for all my quibbles it’s a view I share — then who will assume the mantle of leadership?

Alas, questions of — and questionable — leadership were top of mind last week, and they infused the four key themes that I took away from the conference:

  • Crises of Governance
  • Managers not Markets
  • Sustainability Now
  • DFIs and the Mid-Market

Before you jump to the write-ups, this is the last blast before the new General Data Protection Regulation (“GDPR”) goes live.

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Thanks for reading and sharing!

Alla prossima,
Mike

 

Crises of Governance

Piggybacking off of last month’s newsletter, governance — or the lack thereof — was the biggest theme I observed throughout the conference, and this was on display across three levels of analysis: the individual / firm, the state, and the international system.

At the individual / firm level, there were numerous discussions about corporate governance, alignment of interests, and deal / fund terms and structures. However, the most powerful comment came from Jim Yong Kim, who said to David Rubenstein, “The biggest problem is the explosion of aspirations around the world.” Relative deprivation amidst a global political awakening is a potent cocktail for radicalization and unrest.

Ellen Johnson Sirleaf and Mo Ibrahim provided some memorable commentary bridging the firm and state levels. Madame Sirleaf implored, “It is the responsibility of shareholders to use their boards to ensure transparency and accountability, and improve corporate governance.” Ibrahim quipped, “It’s really hard to improve public governance without improving corporate governance.”

At the international level, Ambassador Chas Freeman gave a rundown of the reasons why “risks are reallocating themselves for reasons that are structural,” and set the stage for numerous discussions about political risk.

Ambassador Freeman also introduced troglonomics to the lexicon — “knuckle-dragging mercantilism that emphasizes bilateral trade balances above all else.” It is a delightful, if depressing, addition for our times.

Freeman’s overarching thesis that “international law no longer protects the weak” evokes Thucydides — not only the Melian Dialogue (“the strong do what they can and the weak suffer what they must”), but also the “terrible chapter” on Corcyra’s civil war (see this month’s From the Bookshelf selection).

It’s hard to be constructive, and I’m generally dour on the world’s prospects in the near term. However, I am cautiously optimistic that we are on the cusp of a generational transition — from a culture of fear and anger at losing what was, to one with the confidence and energy to build what can be (h/t Sir Kenneth Clark).

Hopefully this translates to a revivification of a rules-based, harmonious international system.

🤞

Managers not Markets

In years past, much buzz would be made about the market du jour. Panels were populated with prospective private equity kingpins, and the audience would be serenaded with those sonorous words: structural drivers, rising middle class, boots on the ground.

There was an energy and excitement about the prospects of [pick your market]. Never mind that this frequently happened just as the market was topping. It was fun. Remember Mongolia?

Yes, there were regional panels this year (and even one on blockchain), but that invigorating splash of euphoria gave way to more measured discussions around the evolution of the industry (from private equity to private markets), the need for new metrics (on impact), and more practical issues of managing funds and investments.

All of this may be an indicator of a more institutionalized asset class; but it seems to me a subtle endorsement of the idea that it’s managers that make money for investors, not market timing.

One wonders whether it was ever sensible to hype up specific markets, particularly when there are managers that consistently do well in out-of-favor geographies. I’m reminded of a recent interview with the famed short-seller Jim Chanos:

Barry Ritholtz: The last time you and I sat down for a conversation, about three years ago, you mentioned that back in the day there were a few hundred hedge funds, and out of those, 20 or 30 were reliable alpha generators. Today, there’s 11,000 or so hedge funds …

Chanos: And probably 20 or 30 reliable alpha generators.

Sustainability Now

There has been a palpable shift in investor sentiment toward the importance of sustainable investing. The Sustainable Development Goals (“SDGs”) permeated many speakers’ comments, and there seems to be an effort afoot to segment “impact investing” from mainline PE, with the latter being viewed as key partners for attaining the SDGs.

Most allocators are not keen to sacrifice financial returns for “impact” — define the term as you will — but they are looking for managers that deliver responsible, sustainable alpha.

The irony is that some of these managers may very well be “impact investors!”

Nevertheless, the SDGs seem to offer the biggest tent for the array of investors seeking to do well while doing good, and it is manifestly the direction in which large institutional capital is heading.

DFIs and the Mid-Market

Trillions of dollars of private capital will be needed to meet the SDGs. IFC’s CEO, Philippe Le Houérou, spoke about the organization’s new strategy for mobilizing private capital, which includes working with governments to unlock investable projects, and de-risking investments for private capital.

Presumably this was the rationale behind the “DFI Leaders Panel: Moving from Billions to Trillions” — a chance to proselytize about the benefits of investing in emerging / frontier markets before a quasi-captive audience of institutional investors.

And yet, about 15 minutes into an abyss of DFI navel-gazing, a delegate from a university endowment turned to me and asked, “What’s a DFI?”

🤣

The DFIs do amazing work. But I do worry that the emphasis on mobilizing large volumes of private capital will exacerbate the financing gap for mid-market funds and businesses.

To wit, there’s scuttlebutt that some DFIs may be spending less energy on fund investments going forward. Who will intermediate capital flows to smaller companies?

We’ll see; but these discussions brought to mind two of the findings from our July 2017 report The Mid-Market Squeeze.

Basically, are DFIs catalyzing private capital into EM PE funds if: (1) their preferred ticket size is in the sweet spot of commercial investors; and, (2) most commercial LPs would not be more likely to commit to a fund < $250m in size if its investors include DFIs?

No sé.

CrowdinginoroutVertical

From the Bookshelf

Certainly it was in Corcyra that there occurred the first examples of the breakdown of law and order. There was the revenge taken in their hour of triumph by those who had in the past been arrogantly oppressed instead of wisely governed; there were the wicked resolutions taken by those who, particularly under the pressure of misfortune, wished to escape from their usual poverty and coveted the property of their neighbours; there were the savage and pitiless actions into which men were carried not so much for the sake of gain as because they were swept away into an internecine struggle by their ungovernable passions. Then, with the ordinary conventions of civilized life thrown into confusion, human nature, always ready to offend even where laws exist, showed itself proudly in its true colours, as something incapable of controlling passion, insubordinate to the idea of justice; the enemy to anything superior to itself; for, if it had not been for the pernicious power of envy, men would not so have exalted vengeance above innocence and profit above justice. Indeed, it is true that in these acts of revenge on others men take it upon themselves to begin the process of repealing those general laws of humanity which are there to give a hope of salvation to all who are in distress, instead of leaving those laws in existence, remembering that there may come a time when they, too, will be in danger and will need their protection.

— Thucydides, History of the Peloponnesian War (Penguin Classics: 1972).

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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.