A year ago, major endowments, like Yale, Harvard, and Princeton were seen as the ne plus ultra of sophisticated private investors, regularly posting 20%+ annual returns. Now they are dumping big chunks of their private equity holdings at distressed prices. What gives?
The reason this is odd is that the last thing you want to sell in a bad market is an illiquid asset. Even in good times, you take a discount for liquidity (dunno what current benchmarks are, but in the stone ages, the discount for valuation purpose for privately placed, unregistered securities was assumed to be 20% to 40%. But the current environment is much more like my childhood in the securities industry, so that might not be a bad starting point.). Consider art. In bad times, top paintings suffer least, but the second tier goes for very little, and a lot simply does not sell. Ditto other collectables and estate jewelry.
So why are so many endowments all running for the hills with private equity now? It was a no-brainer as soon as the leveraged loan markets froze as of last August, leaving investment banks with lots of unsold inventory, that the PE industry was going into a sustained downturn. Investment banks bridging loans is a firm-wrecking strategy and a clear sign of a frothy market (the practice was last seen circa 1989 and eliminated bulge bracket investment bank First Boston as an independent player). The big PE firms has done a monstrous volume of deals in 2006 and valuations were rich. Despite the common perception that a public offering is the exit strategy for PE deals, other PE firms more often than realized will buy operations from another PE firm’s deal, and whole companies are sometimes traded. So an important buyer group is lost, which limits exits and lowers prices in aggregate.
And there are powerful synergies between PE deals and public equity valuations. Again, in the heady 2006-early 2007 period. PE firms were bidding for unprecedentedly large firms. and were sufficiently active so as to provide a boost to general equity valuations. In 1987, in the months before the crash, one major Wall Street firm (for the life of me, I cannot recall which one) attributed 75% of the increase in market averages over the last year to M&A activity. In those days, so-called “financial buyers” aka LBO funds, were more active than strategic buyers.
Funny that no one attempted a similar analysis in 2006. but of course, the sell-side analysts then were more into “sell” and less into “analysis” than their predecessors.
That is a very long winded way of saying that if one were to have taken a jaundiced view of things, M&A bear markets tend to be protracted and nasty, and deal values plunge at those times, If you thought you might need to lighten up, the time was a year ago. Even then you would have taken an ugly haircut, but off a a much better valuation.
But were any of these endowments in 1980s LBO funds? Doubtful. KKR did a great job of cultivating public pension funds, but for the most part, the first generation LBO firms did not attract a lot of institutional money. Remember, they were raiders and did hostile deals. The current version is much more white shoe. So few lived through that period, and even those endowments that had LBO investments back then almost assuredly have no institutional memory.
So with that long preamble, the problem is the stated reasons for selling these private equity positions do not add up,. We will get to my nefarious theories in due course. But let’s start with the background and party line.
A push by the richest U.S. universities to unload their stakes in private-equity funds is flooding the market, driving down prices for the world’s best- known buyout firms.
Investors led by Harvard University, which manages the largest U.S. endowment at $36.9 billion, may increase so-called secondary sales of private-equity funds to more than $100 billion during the next year, overwhelming available pools of capital. Interests in funds managed by KKR & Co., Madison Dearborn LLC and Terra Firma Capital Partners Ltd. all are being offered at discounts of at least 50 percent, according to people familiar with the sales.
Crippled financial firms such as American International Group Inc. and bankrupt Lehman Brothers Holdings Inc. are joining strapped endowments such as the ones at Columbia University in New York and Duke University in Durham, North Carolina, in trying to sell private-equity stakes…
“There’s a huge supply-demand imbalance,” said David De Weese, a general partner at Paul Capital Partners in New York, which manages $6.6 billion. As much as 10 percent of the world’s $1.2 trillion of private-equity interests may change hands next year in the so-called secondary market, up from an average turnover of about 1 percent….
Officials at Harvard are in talks to sell $1.5 billion of limited-partnership holdings in leveraged buyout funds, including one run by Boston-based Bain Capital LLC, according to a person briefed on the situation. Harvard and other endowments have suffered lower returns this year and face further writedowns on their private-equity stakes when the funds report their third- quarter valuations…..
Yves here. Apologies for the detail, but you need to get specific to parse properly.
Ahem, This is a year when every asset class is down (Treasuries are not an asset class) globally, only three stock markets are up (one was Ecuador) and Harvard is yanking out money because “returns are down”? That implies returns are positive. If that was true through end of second quarter, the relative performance was great and they’d be making a mistake to sell given the illiquidity discount.
The only logical explanation is that the investors don’t trust the valuations. Are PE firms carrying investments at book value that really ought to be written down? A quote later in the piece provides indirect confirmation:
Blackstone Group LP, whose $21.7 billion buyout fund is the industry’s largest, wrote down the value of its holdings by about 7.5 percent in the third quarter, the New York-based firm told investors last month when it reported results.
Back again to the story:
“Shares of KKR Private Equity Investors LP, which invests in KKR’s funds and trades on Euronext Amsterdam, lost about 25 percent of their value during the third quarter. Blackstone shares lost about 13 percent of their value during that period….
The endowments want to pare private-equity holdings to free up cash for new investments and to reduce the number of managers they have to monitor
Yves here, If you believe that, I have a bridge I’d like to sell you. Back to the article:
The California Public Employees’ Retirement System, the largest U.S. public pension fund, has sold private-equity partnerships and opted instead to invest in secondary funds. Calpers, based in Sacramento, disclosed last month that it has disposed of $2 billion of private-equity partnerships this year…..
So Calpers got this right, They dumped when times were relatively good, and are now buying back pieces at somewhat lower prices (the same downdraft they would have suffered, more or less, had they stayed as long as they were) at the 50% plus “all sellers, no buyers” discount on offer now. Sweet.
Back to the piece:
Also squeezing limited partners is the so-called denominator effect. With the Standard & Poor’s 500 Index down 39 percent this year, institutional investors’ public equity holdings are suffering. When the value of those holdings (the denominator) is lower, the percentage of the overall pool devoted to private equity (the numerator) rises, pushing the percentage of illiquid asset classes like private equity too high….
This is where mechanically administered portfolio allocation rules wreak havoc. We have entered a highly volatile period. Valuations at any quarter end can reflect a recent, and very short lived burst of optimism or pessimism. Didn’t program trading teach us that defaulting to rules about when and how much to sell wasn’t a great idea in wild markets? For instance:
Sales will be driven next year by institutions such as New York-based Lehman, which filed for bankruptcy in September and had more than $1 billion invested in private-equity funds. AIG, which must repay a $60 billion federal loan, has about $28 billion in alternative assets, including private-equity stakes…
Also helping drive down the price of private-equity assets is a lag in reporting compared with publicly traded companies. Since June, the last quarter for which many of the firms’ values have been calculated, the S&P 500 has dropped almost 30 percent.
Part of the problem is the same storyline is being applied to disparate players (in terms of size and immediate need for cash).
I suspect the reality for some funds is that they need to sell for straightforward operational reasons. Maybe it;s portfolio allocation rules, maybe it’s point of view that equities will rebound sooner (and perhaps may also be paying decent dividends.
But how could these supposedly savvy players not anticipated a PE drought, particularly since they coincide with equity bear markets? It seems the real problem is these supposedly conservative investors took on way too much risk.