Venture Capital

The Great Wall of Capital

March 14, 2019March 14, 2019 by Mike

I frequently wonder, “Does it makes sense to think of EM PE as an industry anymore?”

Two recent research releases — one pertaining to fundraising and one to investment — led me to ponder this question anew.

On the fundraising side, EMPEA Industry Statistics show PE / VC funds targeting Emerging Asia have raised $152 billion over the last three years. Of that:

China-dedicated funds have earmarked $70B (N.B. this excludes government guidance funds);
Pan-Asia / regional funds have captured $57B; and,
Country-dedicated or sub-regional funds constitute the remaining $25B.

During the same period, funds targeting all other EM regions raised only $19B (see below).

Last year was a blowout, with nearly $70B raised for Asia-focused PE / VC funds, with a paltry $7B raised across all other EM regions (see below).

Asia has gone from capturing 65% of EM PE fundraising in 2012 to 91% in 2018.

Does it make sense to think of a unified industry when there’s an abundance of capital commitments in Asia, and scarcity everywhere else?

And what are these people who are throwing money at China thinking? (~75% of capital has gone to USD funds over the last three years).

This gets to point two. Bain’s Global Private Equity Report 2019 reveals that $81B was invested in Chinese start-ups in 2018 (32% of global VC capital invested).

Yet, EMPEA’s stats show only $28B in PE / VC investment in China for the year.

A gap of $53B is enormous. It may be down to methodology, but I suspect a large part of that gap is due to the wide array of non-financial investors deploying capital in the tech ecosystem (we talked about this in Sep ’17).

If, in fact, EM PE / VC funds aren’t driving the bulk of the activity in China’s new-economy businesses, then what does that tell us about the asset class as a vehicle for accessing private markets opportunities?

One thing it tells us is that the tent is getting bigger. The universe of players and strategies for EM private markets is expanding, such that it’s difficult to shoehorn the multiplicity of actors into the confines of an industry. (See, for example, our newsletter from last May).

But more to the point, I think it suggests that LPs should reconsider whether traditional asset allocation buckets are an appropriate framework for thinking about long-term investments in EM.

What do you think?

Alla prossima,
Mike

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Очень Плохие Новости

Look, I know nothing about the incarceration of Mike Calvey and his colleagues from Baring Vostok beyond what I’ve read in the press. But I take Mike’s statements about his arrest being a well-connected businessman’s ploy to gain leverage in an arbitration dispute in London at face value.

I interviewed Mike six years ago, and initially, I held out hope that his view on the ability to do business in the market might be vindicated — that independent courts would adjudicate a commercial dispute in a “non-strategic” sector, and that he wouldn’t be locked in a cell for seemingly capricious reasons. But, increasingly, it appears like a garden-variety case of state capture.

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China’s Private Sector

In case you haven’t been paying attention to the evolution of China’s political economy, the FT’s Henny Sender wrote two excellent articles last month that merit your consideration:

Marinate on the following quotes:

Chinese entrepreneurs will privately admit that a bigger motivation for them to sell their businesses [to PE firms] now is the loss of confidence in their own government.

The country’s entrepreneurs have never felt more threatened.

In President Xi Jinping’s China there is no such thing as a truly private company. No corporate entity can say no to Beijing, whether its ownership is in the hands of official or nominally private entities.

What are the actions of the country’s entrepreneurs telling us?

Also, Henny cites a JPMorgan statistic that reveals China’s balance of payments data can’t account for $46B in capital ~~flight~~ outflows per quarter since 2016, “suggesting wealthy Chinese are still finding ways to evade [capital control] restrictions.”

Ruchir Sharma, Head of Emerging Markets and Chief Global Macro Strategist at Morgan Stanley, once shared the helpful heuristic, “follow the locals.” If elites are seeking to get their funds out of the country, what does that tell us?

Reminder: China-dedicated PE / VC funds have raised $70B over the last three years.

P.S. According to the aforementioned Bain & Co. report, Internet / tech companies have been the principal driver of PE growth in Greater China (see below).

P.P.S. Bain & Co. say the median EBITDA multiple for deals in China’s new-economy companies is 31x. Not a typo.

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Factfulness

John Authers had a delightful newsletter that touched upon Factfulness, the last testament of Hans Rosling, the energetic man who used bubble charts to smash preconceptions about the state of the world. John’s punchline is that everyone should probably invest more in EM. (*saved you a click*)

I was so taken by John’s write-up that I immediately purchased a copy of Factfulness and read it in a day. It’s quite fun!

Hans shared 10 “Factfulness Rules of Thumb” to help make sense of the world and its figures. And lo and behold, when I received a copy of KKR’s Annual Letter, I saw: (i) ~50 million retirees and pensioners have exposure to the firm’s investments; and, (ii) it generated ~$1.1 billion in management fees in 2018.

And then I thought: FACTFULNESS RULE #5! Lonely numbers are impressive, so get them in proportion!

Amazing. Using simplifying assumptions, on average, each pensioner is paying KKR $22 each year to manage a sliver of their retirement savings.

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From the Bookshelf

Consider now an old man who complains
Excessively about his death to come.
Nature would justly cry out louder still
And say in bitter words, ‘Away, you rogue,
With all these tears and stop this sniveling.
All life’s rewards you have reaped and now you’re withered,
But since you always want what you have not got
And never are content with that you have,
Your life has been unfulfilled, ungratifying,
And death stands by you unexpectedly
Before the feast is finished and you are full.
Come now, remember you’re no longer young
And be content to go; thus it must be.’
She would be right, I think, to act like this,
Right to rebuke him and find fault with him.
For the old order always by the new
Thrust out gives way; and one thing must from another
Be made afresh; and no one ever falls
Into the deep pit and black Tartarus.

— Lucretius, On the Nature of the Universe (Oxford World’s Classics: 2008)

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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.

Does EM PE Scale?

December 14, 2017July 30, 2018 by Mike 1 Comment

Does the emerging markets private equity asset class scale?

No. I don’t believe it does.

In fact, I think the absorptive capacity of EM PE / VC is as low as $16 billion in new flows per year, compared to the $40 billion in fundraising we’ve seen on average since 2011. At least, that’s my finding in Portico’s most recent research piece: Does the Emerging Markets Private Equity Asset Class Scale?

The inspiration for this think piece comes from Fred Wilson, co-founder of Union Square Ventures, who wrote a fascinating blog post in 2009 on “The Venture Capital Math Problem.” If you haven’t read it, you should. In it, Fred concluded that the volume of exits in U.S. venture right-sized the industry between $15 billion and $17 billion in flows per year, remarkably similar to the conclusion I reached.

While this piece isn’t likely to win me many friends, I hope that it provides some food for thought, and that it sparks some lively conversations. I’d love to hear your feedback!

A humble request. We’re trying to grow our (monthly-ish) newsletter’s audience in 2018. If you enjoy this newsletter and / or know someone who would, then please feel free to share it with them. It’s free to sign up for future issues at www.tinyurl.com/porticonewsletter, while previous editions are available here.

For each new (human) subscriber we get between now and 30 December, we’ll make a donation to Room to Read, a nonprofit active in Africa and Asia that focuses on literacy and gender equality in education.

Happy holidays to you and yours, and best wishes for health and happiness in 2018.

Alla prossima,
Mike

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Mea Culpa

A mea culpa is in order. In last month’s newsletter, I (somewhat cheekily) called out IFC for committing $25M to Carlyle’s $5B Asia Partners V; it was actually to their ($1B target) Asia *Growth* Partners V. Sloppy mistake. I apologize. Thank you to the discerning reader who noticed my error and called me out on it.

That said, I still don’t understand why IFC is funding a fifth-series Carlyle fund. According to IFC’s disclosure of the commitment, as of 31 December 2016, Carlyle held approximately $158B in AUM. This figure is ~70% greater than IFC’s total assets, ~4x the value of IFC’s total investments, and nearly 12x the value of IFC’s equity investments (as of 30 June 2017; see IFC’s consolidated balance sheets at this link).

¯\_(ツ)_/¯

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KKR Quits Africa

We’ve dedicated a decent number of pixels in our newsletters to the issue of large-cap deal flow in Africa. Late last month, KKR decided to disband its Africa team for good. Several of the team’s dealmakers left earlier this year, in part, it seems, because they were investing out of KKR’s European fund and were losing out to French, German, etc. deals in IC meetings.

But a KKR spokesman breaks it down pretty plainly: “To invest our funds we need deal-flow of a certain size. It was especially the deal-size that wasn’t coming through.”

Invariably, KKR’s spokesman continues, “There was enough deal-flow at a smaller level.”

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The Power of Compounding

Albright Capital recently released an enjoyable piece on “The Power of Compounding” in an EM portfolio. The firm compares the returns that three hypothetical long-only investors would have received from the MSCI EM, based on their (in)ability to time the market.

It’s an original thought experiment with results that might surprise you.

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Will Robots Disrupt Private Equity?

McKinsey Global Institute released its analysis of the impact of automation on jobs. They estimate that “up to 375 million people may need to switch occupational categories” by 2030, with up to one-third of the U.S. and German workforces—and half of Japan’s—needing to learn new skills and pursue new occupations.

Will “private equity investor” be one of these disrupted occupations? Could robots do a better job at allocating capital? Given the recent performance figures, at least in EM, one could be forgiven for thinking so.

There’s an alluring argument that private markets are less ripe for disruption than public markets: not only is there less data available, but also the manager can apply sophisticated judgment and hard-earned pattern recognition skills to source proprietary deals, construct a quality portfolio, and create value.

I’m not entirely convinced. Consider an analysis from Dan Rasmussen of Verdad, who, whilst at Bain Capital, examined 2,500 deals representing $350 billion of invested capital:

About one-third of the deals analyzed accounted for more than 100% of profits (no surprise there) and the majority of the deals in the sample fell well short of the forecasts built into the financial models. The biggest predictor of whether a company would be a big winner or not was the purchase price paid. The dividing line seemed to be 7x earnings before interest, taxes, depreciation and amortization (EBITDA). When PE firms paid more than 7x EBITDA, their chance of success plummeted — regardless of how much managerial magic they threw at it. The 25% of the cheapest deals accounted for 60% of the profits. The most expensive 50% of deals accounted for only about 10% of profits.

In other words, all the fancy analysis and financial models performed worse than the simple rule “buy all deals at less than 7x EBITDA” [emphasis added]. A simple quantitative rule worked better than expert judgment.

I was recently speaking with Abby Phenix—formerly of Advent International, now assisting PE firms with customer due diligence—and we ended up riffing on this topic for a bit. In the past, she raised some thought-provoking points about the automation prospects for manager selection (think funds of funds) and investment analysis (think associates), which could enhance productivity and reduce costs (think management fees).

What is it that investors want? Cost-effective exposure to the investable asset or the privilege of paying fees to the middleman?

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Is it Possible to Short Graduate Schools?

This statistic surprised me: the stock of U.S. student loan debt ($1.3 trillion) is now equal to the size of the U.S. junk bond market. Astonishing.

Estimates from The New America Foundation suggest that upwards of 40% of this is tied to graduate school debt. If I could short the graduate education market directly, I would.

Consider that in 2012, 25% of graduate students were burdened with at least $100,000 of student loan debt. Meanwhile, in 2016, the median incomes for master’s degree holders in the United States were roughly $80,000 for males and $58,000 for females. The math doesn’t work, prospective students know it, and there’s a broad-based slowdown in applications (see below).

Effectively, the market for graduate education experienced a debt-financed positive demand shock, universities expanded supply, and now there is a negative demand shock. Schools will need to cut tuition and take a hard look at which costs can be cut.

If you’re keen to learn more about just how much of a mess this is, I wrote a piece about this on my personal blog (source of the exhibit above).

Lots of data. Lots of charts. Oodles of other content.

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From the Bookshelf

I returned, and saw under the sun, that the race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding, nor yet favour to men of skill; but time and chance happeneth to them all.
(Ecclesiastes 9:11)

For what is a man profited, if he shall gain the whole world, and lose his own soul?
(Matthew 16: 26)

— The Bible: Authorized King James Version (Oxford World’s Classics: 2008).

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Status Update

November 19, 2017July 30, 2018 by Mike 1 Comment

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

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

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

A few highlights from year one:

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

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

Alla prossima,
Mike

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The Societal Parasite that Is Facebook

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

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

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

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

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Who Will Make Money in EM Venture?

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

These seem like … insurmountable advantages for an investor?

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

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

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

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This World Awash in Capital

Consider the following. Since 2006:

Global central banks have expanded their balance sheets by more than $15 trillion;
Pension fund assets in WillisTowersWatson’s “P-22” have increased by nearly $13 trillion;
Gross domestic savings across the emerging markets have grown by more than $5 trillion; and,
Total credit to the non-financial sector in emerging markets increased by $33 trillion.

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

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

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From the Bookshelf

The world is always full of the sound of waves.

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

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

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