Anyone who has been around finance a while recognizes the blowout phase. Investors are desperate to put their money to work even when prices are look precarious. Deals go from being negotiated to being sell-side dictation. Rationalizations abound. Remember the line from Chuck Prince, then CEO of Citigroup from July 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Mind you, he was so bold to make that remark right as the Bear Stearns subprime hedge funds were imploding, which kicked off the first acute phase of the credit crisis.
But what most people don’t remember about that Prince quote was that it wasn’t about mortgages. It was about lending to private equity which had also gone into a moonshot in 2006 and early 2007. And as we’ll discuss in more detail soon, private equity again has the classic signs of being in another “devil take the hindmost” phase of frenzied capital commitments.
And the reason more of Citi’s loans did not come a cropper was that the “goose asset prices” that has housing prices and consumer confidence as its main targets incidentally bailed out private equity. Even so, private equity performance post crisis has been underwhelming, with investors on a widespread basis failing to meet their private equity benchmarks. That means they have not earned enough to compensate the risks of that strategy.
Even so, we know the reason Citi escaped being nationalized as a result of its overconfidence was the heavy representation of board member Bob Rubin acolytes in the officialdom, most important Timothy Geithner as New York Fed chairman and later Treasury Secretary.
Last year, average prices paid, measured in EBITDA multiples, were at record highs, exceeding the 2007 peak. Yet while past bubbles show that crazy prices can always get crazier, there are warning signs that a peak is probably coming sooner rather than later. The Fed is clearly eager to raise rates as soon as it has any thin justification to do so. A rising rate environment will hit long-dated and higher risk assets the hardest. That means private equity is doubly exposed.
And if the Fed does not continue tighetening, that would likely be the result of deflationary forces continuing to bite, say a downdraft from China, a shock wave from Europe due to a Brexit vote going through, or other centrifugal forces on the Continent strengthening (say Merkel losing her Chancellorship, or Marine Le Pen continuing to gain in French polls). Deflation is not a friend of risky assets. The best place for investors in deflation is in cash, cash-equivalents, and safe bonds. Deflation increases the cost of debt in real terms, which again is punitive to highly leveraged transactions, since deflation also leads businesses and consumers to tighten their belts, hurting corporate revenues and/or profits. And the popularity of negative interest rate policies only makes a bad situation worse. It hurts the incomes of retirees and other savers, leading them to curtail spending. It’s destructive to bank; bank pressure is reportedly one of the big reasons the Fed is so eager to ‘normalize”. It’s also destructive to investors like pension funds and life insurers.
But the desperation measure of these long-term investors is to chase returns, risk be damned. And with hedge fund coming more and more into disfavor, private equity is an even hotter ticket than before.
Notice how this article from Pension & Investments, Private equity managers regain the upper hand, also belies the claims of the Securities & Exchange Commission and many investors that they are pushing back against private equity abuses. If you aren’t wiling to walk from a deal, you have no leverage. And it’s not just a matter of rejecting a deal to try to influence the seller, which just won’t happen in a frothy market. You need to walk because the terms are not acceptable. But no one who invests in private equity appears to have acquired this basic level of investment discipline.
From Pensions & Investments:
Private equity investors are getting a dose of the new normal as the hottest fund managers again demand general partner-friendly terms and fees that investors have not seen since the pre-crisis go-go fundraising days.
Some managers are again charging “premium carry” similar to 2007 vintage funds and are eliminating terms from their current funds that are designed to protect limited partners, such as preferred returns, also called hurdle rates, and clawbacks.
The fact that investors are waiving clawbacks is insane. A clawback is a mechanism for settling up at the end of a fund’s life for having the general partner reimburse excessive carry fees. Now there’s plenty of evidence that clawbacks are abused. Most investors have no ides what they have been paying in the way of carry fees, and hence no check as to whether they were being ripped off. Those general partners that would or felt they had to ‘fess up that they’d gotten more in carry than they were entitled to (due to early deals which had done really well being offset by later dogs), virtually never pay out the overage. Instead, they tell the limited partner they will get a “special deal” on the next fund. Why should a limited partner wind up pre-committing to a next fund for a general partner that hasn’t done all that well? But even with limited partners failing to enforce this term, it’s nuts to give up a long-established contractual right.
Back to the story. It’s good to see at least one investor showing some spine:
Most investors are “term takers,” said Jonathan Grabel, chief investment officer of the $13.3 billion New Mexico Public Employees Retirement Association, Santa Fe. “There’s a supply-demand imbalance,” Mr. Grabel said. “There is greater demand for allocations to these funds than there is supply … and the demand by LPs is voracious.”
In the last six months, New Mexico PERA officials have walked away from some alternative investment funds because of the terms. And it is not always economic terms that are the deal breakers, he said.
Some managers are changing terms such as key man provisions and fund extensions.
“I would be more comfortable if GPs were putting more capital at risk, but not when GPs are decreasing their commitments to the funds and are also ratcheting up unfriendly terms,” Mr. Grabel said. “It leaves a bad taste in my mouth and hopefully, other LPs.’”
Limited partners fear that if they complain, the private equity manager will at best cut back their commitments or, at worst, bar them from their highly sought-after funds.
For GPs, this is a golden age of private equity and GPs can get these terms due to the supply-demand imbalance, Mr. Grabel said. This is the case, even though not all the highly-sought after funds are “the best or ones with the brightest prospects,” he said.
Grabel seems to recognize, but doesn’t state it as clearly as he might, the fallacy of the “hot fund”. It was once the case that private equity funds in the top quartile had a nearly 50% chance of being a top quartile fund on the same managers’s next fund. But the belief that investors can beat the overall unattractive typical private equity risk-adjusted return rests on several fallacies. The biggest is that persistence of top fund outperformance is a thing of the past. Recent studies have ascertained that a top fund manager is now less likely than chance to be a top performer next time around. Investors might as well use a dart board rather than chase top performers. Second is that even in the days when there really was top quartile performance, 77% of the fund managers could cut their results so as to claim they were top quartile. Third is the Lake Wobegoe delusion. As we wrote in 2014:
Rather than question the logic of investing in private equity at all, everyone in the industry has convinced themselves that it is reasonable to believe that they can be the Warren Buffett of private equity….
Fundamentally, this is an intellectually dishonest exercise, and diametrically opposed to the way many public pension funds construct other parts of their investment portfolios. With public equity in particular, it’s almost certain that a significant majority of U.S. pension fund assets are invested in index funds. That’s because pension funds have recognized that, collectively, they cannot do better than average, and that after paying active management fees, actively managed public equity portfolios typically perform worse than the market average.
So it’s not as if these investors are so clueless that they can’t grasp the point that all of them cannot achieve above average results, let alone significantly above average results. Instead, with private equity, there is a desperate desire to be in the asset class for reasons that probably reflect a combination of intellectual capture by the PE managers, political corruption in legislatures that control public fund board appointees, and the need to have a strategy that could conceivably solve the pension underfunding problem over time.
But private equity investors hang on not just to the performance delusion, but also the notion that they are “partners” in these funds in something more than a narrow legal sense. And private equity fund consultants, who won’t have any reason for existing if more investors decided to walk or construct private equity-mimicing strategies via public stocks, which recent studies have flagged as viable, advise LPs to knuckle under:
TorreyCove’s Mr.[David} Fann says it’s simply a broken supply-demand equation. The vast majority of investment funds have hard caps, so whether they want to or not, limited partners are competing for the prized spaces in these hot funds. “The very best funds on the market are reverting back to premium terms and conditions a la 2007. Most LPs are frenemies. As a result, public pension LPs are forced to choose between holding the line on economic, structural terms, or transparency issues in a high-demand fund and risk being tossed out, or simply being acquiescent,” he said.
“If investors (pension funds) want to compete with endowments and foundations, they have to accept the terms,” Mr. Fann added.
At the same time, lawyers working for some of the hot managers are using a divide and conquer approach with limited partners.
While there are private equity firms attempting to ensure a level playing field, many are playing hard ball, said Mary T. Hornby, managing director and general counsel at New York-based private equity fund-of-funds firm Abbott Capital Management LLC.
Some general partners “go out with terms that clearly are just an attempt to start with the best terms the GP can get and they figure they will make the LP ask” for concessions, she said. “It is more of the legal adversarial approach like in a courtroom.”
Observe how Fann, who is supposedly being paid by his clients to be intellectually honest, is perpetuating the “hot hand” myth. But we’ve pointed out previously, in the context of CalPERS, how despite pretenses otherwise, private equity consultants are ultimately loyal to the strategy, and not their clients, another example of how the advisors in private equity perpetuate intellectual capture.
In other words, this movie is unlikely to have a happy ending as far as investors and the taxpayers who backstop them are concerned. But don’t buy the story that no one could have seen this coming.