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.
sixth paragraph has inflation in a few places you most likely meant deflation
otherwise, I can only ascribe this sitution to corruption of the investors. because a rational investor that really believes in some fiducary duties, with reasonable aum, would drop all but index investments by now (and would focus on being able to do index on differnt assets – and I don’t mean hedge funds and the like, but assets before the word got corrupted).
. . . I can only ascribe this sitution to corruption of the investors . . .
It’s desperation of the “inwestors” (channeling El Erian).
Economists tell us all day long how destroying manufacturing here and shipping jobs to no wage nations is no biggie. That the workies in those nations should be grateful for being exploited for their own good, but I am getting off track.
Wrecking the wealth creating sector of the economy results in less wealth to spread around, but no economist would be caught dead arguing that, no, the problem is always not enough debt.
We will all be Flint if we don’t kick economists from their throne at the policy table.
Public pension funds get their money from taxing profitable businesses, and the cycle starts here. The executives decide to fire workers here and exploit workers in no wage nations, which leaves a funding hole for the local government, which made pension promises when times were better. Needing a 7 to 8% yearly growth in that fund to cover future pension payments, while executives serially and simultaneously fire manufacturing workers eventually leads to desperation on the part of pension funds, and fall for the lure of Pirate Equity.
Pirate Equity then uses the pension plan’s money to buy companies that it loots, loading them with moar debt and if that company has a small pension plan, stealing that for themselves, leaving a wrecked hulk, that can’t be taxed as it makes no profit anymore, deepening the funding hole of the pension plan, leading them to fall for the lure of Pirate Equity.
The pension plan managers lack the self awareness, that every time they go a round with the Pirates, the plank they walk get’s shorter, until nothing is left.
Aargh, the cost of not proofreading due to trying to get the post out before the e-mail cutoff. Fixed, thanks.
Other key thing about PE returns generally is that the data is really poor quality–lot’s of self-reporting, few controls.
I have not seen tgat many buyouts of public companies recently and no IPOs. Are they breaking their companies up or do we just have pure musical chairs going on?
Thanks to NC’s reporting I’ve avoided some bad investments. I’m investing my own small funds, not other people’s money. Why are pension boards more indifferent or reckless with other people’s money than they would be with their own money? That’s a question.
Thanks for this report.
People have been saying our current bubble would be done for a long time now, although I’m not even sure this qualifies as a bubble. I’m not even sure what to call it. I’m surprised it’s gone on this long, but every time someone says the music is about to stop, or some crisis seems to be on the horizon they find another way to keep it going. I don’t possess the technical knowledge to sort through that much of this, but who knows anymore?
I’m with you. The problem is that we know the system is not rational, despite the protestations of its gurus (Economists and Pundits) and that it is a house of cards. But the very irrationality of the thing makes it impossible for rational outsiders looking in to have a clue when and how it’s going to blow up. The scary thing about the idiots running Europe is that their extend and pretend strategy has paid off, not just for the elite but for the political parties that most slavishly serve that elite. Their banks may be insolvent and the standard of living in Europe may have fallen significantly over the past 10-20 years (depending on where you live) and is poised to fall even further, but you, the elite, are doing just fine, and the people who control the cops and the armies are in your back pocket, so no worries at all. This result is utterly irrational, but nevertheless is true. What good are the calculations of a sane man in an insane world?
The flow into PE is going to continue until the asset class fails. Public pension plans can’t make their investment assumptions with liquid stocks and bonds, so they have to throw a slug of PE into their optimizers in order to get projected returns that match or exceed their assumptions. Of course, they’re also going to throw in a dash of hedge funds in order to dampen the volatility of their riskier pension portfolio. This toxic cocktail allows public pensions to put off making hard decisions and as you aptly point out, it will not end well.
Big fan of your work!
. . . allows public pensions to put off making hard decisions . . .
Can you outline what those hard decisions are really about? Is it who won’t get paid after the looting is completed?
I have to differ with you on this. Private equity even now is only 6% of the global equity markets. PE falls of the cliff when the public equity markets do. It’s ultimately levered equity and it is highly cyclical. It’s not bog enough to drive equity markets on any sustained basis. In 1987, Goldman estimated that 3/4 of the stock market gains were due to takeovers, which included raiders (so the Drexel extended family) as well as corporate deals that were mean to be preventive. We know how 1987 ended, and even though LBOs kept going to a degree till 1989, the end of 1980s crash and workouts were brutal, and the industry didn’t come back in a meaningful way till 1995.
The industry got a second lease on life after the 2008 crisis due to the extreme measures central banks took that incidentally helped risky investment strategies like PE. But even so, the overwhelming majority of PE investor have not met their benchmarks even when those benchmarks are permissive (using a risk premium to the S&P 500 as opposed to indices of stocks more comparable in size to PE deals). Even Josh Lerner has been forced to admit that PE outperforms so modestly that it’s not worth being in it unless you can be in the top quartile, which as we’ve discussed repeatedly is a fool’s errand.
Your argument reminds me of the weight of money arguments I heard when I was working with the Japanese in the later 1980s: “The capital flows are so great the Japanese stock market will never go down.” I was hearing this from people who on some level had to know better but had gotten too close to the situation. Your argument isn’t anywhere near as doctrinaire, but It actually rests on the same logic, in fact, PE isn’t big enough to determine the public stock market valuations over anything much more than a comparatively short term. And public stock investors can and do change their risk appetite quickly.
Its the spiral that bankrupted the Lloyds of London insurance market – insiders passing the same stuff round and round to each other at ever increasing prices and creating illusory profits for their investors.
What is extraordinary is seeing insurers and pension funds, who both pay out real money, getting into this game. I suppose they go to a bunch of gamers and offer a large investment in return for ‘get me out first’ terms.
I’ve read research suggesting that buying a few good small cap equity mutual funds gets you the same return as PE at a lower fee, so I’d agree with the theme that PE is not worth it. At the same time I’ll suggest there must be some good PE managers out there, especially smaller one’s that can buy into smaller more profitable deals. If i was an FA/consultant I’d suggest the mutual fund or just a small cap ETF.
But if PE is a poor deal for the investor it will ultimately be outed and the manager will be out of business, right? Or maybe you just view it as a scam that needs to be regulated away? Not really sure.
One suggestion: make it easier and less burdensome for small companies to go/be public. I prefer the idea of finding existing regulations to remove making the PE model less appealing.