Funds have invested in PE due to its Madoff-like volatility profile. Ironically, they forgot that this led to a collapse.
By Harris “Kuppy” Kupperman, founder of Praetorian Capital, Adventures in Capitalism:
For the better part of a decade, institutional investors have redeemed capital from active strategies and dumped it into Private Equity (PE). What’s the benefit of PE for allocators? You get to have levered equity returns without the volatility of actually owning public equities. Unlike stocks that often fluctuate wildly, PE is marked-to-model (M-T-M), hence quarterly volatility is minimal. Then, when there’s a liquidity event, you get to see how well you did.
Or at least, that was the theory. However, by the time of the liquidity event, usually someone else is in charge of the position. Meanwhile, you’ve used the nice smooth M-T-M to earn yourself a bunch of bonuses and maybe even a promotion to somewhere else that’s ring-fenced from your allocation decisions at your prior job. In many ways, the funds and the allocators themselves are both incentivized to mark the numbers higher and hope that they’re proven right.
Over the past year, I have been highly critical of the Ponzi Sector. You have businesses with no hope of ever showing profits, focused on using VC capital to create revenue growth in the hope of an IPO. As the IPO window has now closed, these companies are in something of a bind; if they slow growth to reduce losses, they become no-growth incinerators of capital and if they keep going, they may find that they cannot make payroll one day—remember WeWork?
You also have the issue of the VCs themselves; do they really want to fund this thing anymore? A year ago, they knew they could put money in at a $1 billion value because Softbank would do the $10 billion round and then they could dump it on retail. Even if it was a down-round from Softbank, who cared, they set the mark and everyone else felt like they got a bargain in the IPO.
However, times have changed.
Who would still value a fake business at $1 billion if there was no hope of an IPO in the near future? These sorts of little dramas are getting sorted out behind closed doors and not a day goes by without us hearing of another round of VC unicorn layoffs. As the VC ecosystem has a slow-motion coronary, it’s worth asking what else looks like VC; where else can you mark-up your friend’s portfolio if he’s willing to mark-up yours.
Well, PE sure looks similar—fake marks, unrealistic expectations and a lot of incentive to ignore reality in the hope of bluffing your way into an IPO. In VC, this all ended when Uber (UBER – USA) and Lyft (LYFT – USA) both had down-rounds, followed by WeWork failing to raise capital at any price. Since then, we’ve seen failures by many smaller companies like Casper (CSPR – USA), which serve to remind equity investors why they shouldn’t buy VC IPOs.
However, PE was notably absent in this drama until recently. Is the bankruptcy of EnCap’s Southland Royalty, PE’s very own WeWork moment?
I’m not trying to pick on EnCap; I’m sure they tried their best. That doesn’t change the fact that they marked their Southland asset at $773.7 million at the end of Q3/2019 and then marked it at zero a few months later.
Having been in the investing world, I can commiserate with EnCap. Sometimes it’s really hard to tell what something’s worth. However, this isn’t Schrodinger’s cat; it’s either a healthy business or hurtling towards bankruptcy. It can’t be both and it should have been aggressively impaired heading into bankruptcy.
Interestingly, while EnCap gets the opprobrium for being first, they certainly won’t be the last or even the largest to report similar drastic write-downs. Last week I had lunch with a friend who’s rather high up in the PE world. He repeatedly made the point that many of the marks are simply wrong and a surprisingly large number of mid-decade vintage deals are going sour at an alarming rate. I suspect there will be many more surprises coming—the sort of multi-billion-dollar write-offs that will forever change PE’s image of low-volatility capital allocators.
The odd thing is that allocators invested in PE due to its Madoff-like volatility profile. Ironically, they also forgot that this led to a collapse at the end. If last cycle’s crisis was caused by Madoff’s admission that it was all fake, will this cycle be bookended by PE’s similar admission?
The money seeking low volatility will likely be surprised and then revulsed simultaneously. So, what happens to all the PE deals when the current funds expire?
It was always assumed that Vehicle IV would purchase assets from Vehicle III (a Ponzi Scheme in its own right). Without capital for a new fund, you need to have an actual third-party monetization event—either a sale to a strategic or an IPO. My hunch is that these valuations undershoot drastically.
My friend was joking that most deals he’s looked at lately aren’t even worth the debt associated with them—there’s literally zero equity left and the marks are in fantasy-land. I suspect that we’ll soon learn that the last decade of PE was little more than an exercise in valuation gamesmanship and fee generation for everyone involved (GPs and allocators are equally guilty here).
The past few years have been unusual in that private businesses routinely traded at premiums to public businesses. Any student of common sense would understand that immediate liquidity and broad access to capital ought to mean that public companies deserved a premium multiple—even after the added costs of being public.
The fact that this wasn’t happening ought to have been a clue that something nefarious was going on. It only lasted this long because an epic liquidity bubble coupled with allocator’s desire to never re-live 2008’s volatility, pushed them into chasing Ponzi Schemes in all their varied forms. The VC bubble burst the day that WeWork went from being worth tens of billions to almost missing payroll. Something very similar seems to be happening in PE as we speak and Southland Royalty is the canary in this coal mine.
What are the investment implications?
When I started in the investment business, companies went public to raise growth capital. For the past decade, this has been unnecessary and counter-productive. Why expose yourself to valuation by the masses, when you can massage numbers and raise money privately—often at a premium valuation?
I suspect that over the next few years, this trend will revert to historic form and companies will once again need the pubic markets to raise capital—especially as their PE shareholders are forced down the IPO road as a form of liquidity. Oddly, this will be at precisely the moment when the smallest percentage of capital in financial history is controlled by active managers. Could this be an unusually attractive moment for active managers to buy into IPOs from distressed sellers?
The more fraud that we ultimately witness in PE, the more likely it is that these liquidity events will have the sorts of stigmas associated with them that lead to incredible prices. Stay tuned; PE and VC controlled the past decade due to asset allocators with multi-decade duration mismatches, going out of their way to avoid monthly volatility—if that sounds illogical to you, it’s because most allocators are human and respond to social pressure in their tight-knit finance communities. They do what their friends are doing, as career risk is just too great—especially when it isn’t even their money when it all blows up.
The twin VC and PE bubbles are now unraveling—rapidly. I have a feeling that the next few years will be a golden age for active management as PE aggressively disgorges tarnished assets back into the public markets often at pennies on the dollar. For active portfolio managers, this will be the sort of thing that fortunes are made of. PE is having its WeWork moment as we speak—investors will lose fortunes from their goal of dampening volatility. I don’t think they’ll then hazard back into PE for decades. I can’t wait for the bargains that are created… By Harris Kupperman, founder of Praetorian Capital, Adventures in Capitalism.
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I hope and pray that my favorite presidential candidate of the past had all of his unearned dough in WeWork, Uber, and Carsper. The boy from Bain surely ruined ongoing companies.
Yeah I know, the article is about PE rather than VC. I just wanted to project some hatred.
There’s lots of reasons to hate them too That’s for sure
Erle,
It’s about both :-]
I read this article closely, and I guess I am too much of an investing neophyte to understand the difference between VC and PE. To me, both are “private funding?”
Yes, you’re correct, both are “private funding” entities. But typically (and that distinction has been violated many times), VCs fund startups, and PE firms fund established enterprises, often taking them private when they’re publicly traded. PE firms operate on debt and leverage, and do leveraged buyouts (LBO); VC firms normally invest equity capital.
Both share a gambling problem.
PE get a door prize when they enter the casino (“special dividend”) and get the roulette tables to sell when the money runs out.
VC just bet on 22 red.
I hope the comment about the PE assets selling for pennies on the dollar is especially true for the real estate, and especially the single family residential real estate the PE folks have purchased.
Time and enough for some kind of rule about ownership of single family residences being owned only by owner/occupiers; that alone would bring at least some sanity to that market, and perhaps even nudge it away from the commoditization of the last few decades.
VintageVNvet
I share your distaste for hedge fund ownership of huge swaths of residential real estate (RRE), but as a long time owner of residential rentals, I can tell you the market for RRE is fairly priced and has been for decades IF the asset can be monetized as a rental.
The disconnect in pricing is in the commoditizing (as you point out), combined with Buyers’ wish lists and willingness to overpay (due to near-ZIRP). The reality is, as we learned in the great recession, there are people who NEED to be renters – they lack financial and social maturity. It’s not that they can’t be homeowners someday – they were lured in and took the bait – equally at fault.
When defaults hit the market, Mom n Pops like me pick them up and make them pretty – paying FMV for the asset, and providing clean affordable rental housing for a much needed rental market. The RRE market always resets itself. Some sort of top-down legislation disallowing investor ownership of RRE would, in my opinion, do what pretty much all government intervention into markets does….destroys the market and inevitably picks the winners and losers, which is what we have right now. Had TARP and near-ZIRP never happened, RRE would be priced right.
I rented from a mega landlord. I can’t wait for rent control to put them out of business.
As I remember Beardawg, you operate in the midwest. What is the return on fairly priced rental real estate where you are, and where is that? In the Los Angeles area, real estate for rentals or for shelter, makes sense only as a speculative pursuit.
They bought the residential and others for pennies in 2009, and could have dumped it at the highs since, waiting for the next big bust. That’s what PE is all about, or should be if done right, thus the high returns (heavy on the done right).
“My friend was joking that most deals he’s looked at lately aren’t even worth the debt associated with them………….”
————-
There are so many publicly traded companies with the same profile. When the attitude toward the FED swings a bit in that they will keep the bubble inflating, NFLX and such will have fun charts. PE stuff can’t even be charted.
I am convinced there is no price discovery left in either bond or stock markets anymore. After all these issues the *markets* is moving back to unchanged today. And the hang seng is barely unchanged. There is no economy left in China anymore. And the entire semiconductor sector is about to stop.
I know I don’t see any end to this until we somehow reach a point where all the major market participants run things to a point where they are cornered into a desperate situation where they are forced to finally realize that “money can’t be eaten [or drank].” Until then the great dance of delusion goes on indefinitely. How I miss reality.
Greek 10-year bonds yields are 60bps lower than U.S. Treasuries. And the Vanguard International Bond Index ETF has a large swathe of negative yielding bonds from Europe and Japan.
Investors keep buying these things in retirement funds as part of their Target date funds or “Balanced Funds”. People aren’t interested in price discovery, it seems. Or they are too busy working to care.
What happens when the entire economic framework of a nation is fraudulent ?
We’re about to find out. (Thanks, Fed)
The 1849 book, Extraordinary Popular Manias etc mentions a company that sold shares during, I think, the South Sea Bubble, whose business plan was ‘so secret it cannot be disclosed’.
Some of the disclosure statements today may approach this standard in their opaqueness. The buzzword count is a leading indicator.
This is starting to remind me of when Minyanville was blathering on about “Simulacra and Simulation”.
yes, that was the South Sea Bubble premise.
However, most bubbles make sense initially. Take Dutch Tulip Mania: tulip bulbs were rare, prestigious and in demand. Buy one, take good care of it and next year you can split them up and have several tulip bulbs to sell while still keeping one for yourself. You can’t do that with houses or stocks although many “investors” seem to think so nowadays ;(
What can I say? I don’t have any skin in this game. Never have, never will.
Me either I never believed in it and therefore I missed out on the opportunity but somehow I don’t care much Gold and Silver are catching a nice bid today and that’s nice to see
Unfortunately we all indirectly have skin in the game. So much money of society (pensions and such) is invested through PE and other modern takes on the Ponzi Scheme that the social fallout will effect us all if it all unwinds suddenly. Shocks will percolate through the financial system and economy that will punish us all in lots of indirect ways. Even if you are a survivalist hiding in your bunker with your caned goods, gold, and guns if this unwinds too fast it will mean you will need to use more bullets to shoot the increased number of desperate masses trying to force their way into your bunker to eat your canned goods, so it will still cost you more too just very indirectly.
RD/Fred/Nat: check/check/double-check.
Kuppy has further clarified a bit of the long-running madness (wheel of history?) we follow here on WS.
may we all find that better day.
“Unfortunately we all indirectly have skin in the game.”
You may not be interested in history (or gvt worker pension fund debt), but history (and gvt worker pension funds) are *very* interested in…*you*.
Is there any way to take advantage of your central idea that PE decent stuff can be bought up by a publicly traded fund?
Anyway, an intriguing article.
My feeling has always been if it’s offered for sale by PE it’s not worth buying; any assets worth anything have been stripped out and sold, and the cash has been cleaned out with a special dividend to get back the purchase price after the shell has been loaded with debt.
Often the only thing remaining is some recognizable trade name that fairly quickly dies again under debt load. There may be some cherries out there, but it’s more like a lottery.
Most of what they buy falls into the same category, a company not good enough for the big players, but good enough to loot.
Private and public companies buy companies from PE firms with regularity. Do you think they don’t do their due diligence? They are typically the same type of person with the same finance training and profit motive. If what you said was true, there would be no buyer for any of these businesses, and clearly there are or PE would cease to exist.
The real problem is artificial elevation of the value of these companies related to the Fed supressing interest rates.
Great article Kuppy. Thanks.
Well,10 year treasury yield is lower than 1 month, so Fed will cut rates again. Plus extra cut for virus, and another for insurance. We’ll have 10-20 Trillion dollar corps.
How do PE puke a bust deal onto the market? As a way to get more equity in? Or the loan owners IPOing post-restructuring?
Kuppy has a great way with words: “… as Private Equity aggressively disgorges tarnished assets …”
A less refined translation: “… as investment cartels throw out the trash.”
When all is said and done, any business worth owning or investing in has to make money. Yeah, it’s been damn near forty years since I took Econ 101 at the University, but if I recall there’s a chapter in my textbook, ‘The Price System and Resource Allocation’, that covers the difference between making a profit versus taking a loss.
Or you want to own the business for other reasons. A great example of that has historically been newspapers and football clubs.
What else is mispriced? How about the entire repo market. There is basically one buyer and one price to hide the ugly truth.
Congrats, Petunia!
Use of the word “price” instead of oft-misused “value”.
I would like to see the word “price” used more often than “repo rate” because then it would be more obvious there is no real market. The fed is setting the price for the entire market when they set the rate everybody has to use.
The twin VC and PE bubbles are now unraveling—rapidly.
That should slow down the litany of victims and the liquidation of the US economy. Probably not enough though.
And not in time to prevent the demise of Fairway, an admirable chain of stores based in NYC, from the story on Naked Capitalism today.
Or dozens of others. Pillaging perfectly good companies out of existence is contrary to the public interest (which is supposedly the reason why they’re chartered by the state) but the nasty tactics employed are technically legal. And if they weren’t legal the predators would corrupt governments to make them legal. People forget that businesses are regulated because really bad things happen when they’re not. Other bad things happen when they’re not regulated properly, for example, in such a way as to pick political favorites.
This is not the MO of most PE companies. They can make massive profits from building a successful company, and can lose money if a highly leveraged company fails, although they can strip some profits from failing businesses. Leveraged deals do very very well when the underlying business grows rapidly and is profitable. The grocery you describe in NYC did yield a profit to the PE firm who purchased it, but their profit would have been far greater had the business been successful. Are you suggesting PE firms purposely choose a less profitable asset stripping strategy primarily?
Oh puh-leeze.
Happy1:
“Are you suggesting PE firms purposely choose a less profitable asset stripping strategy primarily?”
Can’t think of a better and quicker way to make money!
“I’m shocked! Shocked! To think that would ……be a strategy!!”
Back in the bad old days.
It was all about future cash flow.
“hard to tell what something’s worth.”
Clearly written article on a bizarre craze in the financial markets.
That will be corrected.
Tesla Electrical Schrodinger’s cat doesn’t exist. But tell that to investors.
There’s comfort in knowing we’ve transitioned from uncertain demise to certain demise.
stability is a very under-appreciated thing these days. once one accepts certain demise as a default option, reasonable courses of action open up accordingly.
Shooting craps in a rigged game.
Of topic but noteworthy: Tesla has a two billion dollar secondary stock offering and stock is up $47. I have taken several high level mathematics courses some dealing with imaginary numbers. I will have to review that material.
Integrating the imaginary numbers then correcting for time factors might get you close? ;)
∫ a^ + b^ > ci^2
Assuming the multiplicand of the doom field radiation rises exponentially, it could rupture the very fabric of causality.
Not sure of the result though, I keep getting a complex denominator in the causality ratio.
What a wag. You got at least one laugh.
Mean Chicken:
I have a simpler “formula”:
1+1=3
For extra fun Morgan Stanley just raised their bull case of Tesla to $1200 a share:
https://www.cnbc.com/2020/02/18/morgan-stanley-raises-its-bull-case-on-tesla-to-1200.html
Please let me know if your review of imaginary numbers … or anything else, lends any insight into the nature of the current market. My own attempt to understand things as they are and are going has lead me to just give up, so I would really appreciate some sort of rational model from better minds to try and help me understand things like Tesla’s stock price, which I am thoroughly confounded by.
I think they have included the carbon credits for all the trees that Tesla is razing for their German factory, and that will be burned as sacred “bio-fuel” blessed by EU madness.
I heard that Papa Son was actively buying up millions of Tesla shares pushing the price higher and higher.
The end game is to then have Softwank make a play for Tesla at $2000 per share and personally cash out.
Don’t quote me on that. He may just be pushing up the shares just because the monkey threw a dart at that dot
LOL
This is nothing new. It is quite pathetic that Kuppy is the only person in the finance game talking about it.
Vista Equity? Buying up tech companies and revaluing them as they see fit? FBI raids of business partners? Come on. But nobody will do any research….although its all right in front of everyones eyes
Just let forbes put certain folks on front covers and the fraud will continue.
Feel free to do some digging. If you do, you may save pensioners amd others later down the line when mainstream journalists finally let the cat out of bag
https://www.institutionalinvestor.com/article/b1k04s2x8b9lh6/Vista-Equity-Sued-By-Portfolio-Company-Founder
Great piece, Kuppy!
Please b sure and come back a few Years hence and point out where the values are for all of us blind mice.
Yes, it was an excellent piece – brief but gave some “inside baseball” insight into how valuations are gamed.
I was in the VC/PE markets back before and after the dot.com crash and the very same thing was going on then, perhaps not to the dollar weighted level it is now, but it was no different. All of those PE guys sending in valuations on companies that they had been carrying at cost for the better part of six years of an 8 to 10 year fund cycle. Laughable then, laughable now. Of course it is anymore laughable then the debt driven stock buyback stock markets we have now. It is result of global money printing machines combined with the most fractional of fractional reserve banking.
I’m not in the PE industry, but have been an observer of their activities in my field of employment, healthcare.
The deals I have observed over 20 years do not include “asset stripping” and other such activities, they involve smart business people making deals in growing industries in response to market needs. Some have been extremely successful, some less so, but my long term experience as an observer in this space is that PE firms make their money by building successful businesses, not by asset stripping and paying themselves undue dividends and such. And some of their deals have not been successful, although this is a minority.
Of course there are examples in retail sales that include the LBO asset stripping model many of the comments address. I would guess this is a minority of PE deals, because growing a successful business is so much more lucrative.
There’s a lot of PE in the grocery business and it is not improving the business. It has worsened the entire food industry in my opinion. My grocery bill has doubled in the last 4 years and the food is not any better. Of course, the govt doesn’t know about food inflation.
or healthcare inflation, that was fixed by the last guy supposedly. or was it the guy before him, they all run together at this point…
You can lay the blame for food price inflation squarely on the Fed, companies of all kinds are passing on those increased costs. And for the commenter below regarding health care costs, large “non-profit” hospital chains and big pharma are responsible for almost all of the increase in health care costs, PE is a bit player.
When this observer hears the dreaded ‘PE’ uttered, what comes to mind? Cerberus Capital (mis)Management. Lovely choice for naming the firm. In Greek mythology, Cerberus is the three-headed dog that guards the Gates of Hell, preventing escape.
At least no one should be unsure of just who these fleece demons are working for.
Paging Heracles!
I’m not trying to pick on EnCap; I’m sure they tried their best. That doesn’t change the fact that they marked their Southland asset at $773.7 million at the end of Q3/2019 and then marked it at zero a few months later.
Now that is funny stuff!!!!
Great article – and it can’t happen soon enough
When assets are valued by spreadsheets and not by profitability and cash flow, values are guaranteed to climb. I co-founded Yucaipa 30+ years ago (when no one used the term private equity) and we made money by acquiring underperforming companies and actively managing them. I’ve never understood VC valuations and observed that VC investors I’ve known can’t enlighten me. I gave up searching for acquisition opportunities more than a decade ago. I found that my sense of value could not compete with that of PE buyers. I’ve watched as one liquidity event after another is achieved by a sale by one PE fund to another (or through an IPO that later gets “repriced” by the market) and wondered when the Ponzi scheme would come to light. Perhaps that day approaches. It promises to be ugly.
This article and the comments are funny. Lots of opinions about PE by folks who know very little and complain about PRIVATE markets. Please, stay in your lane.
Be careful – your lane may be endangered by oncoming traffic.
TrojanMan,
Why don’t you try to stay in your lane.
Enlighten us TrojanMan, if you have something to offer.
It is called private equity for a reason – it is private. Bankruptcies in the big cap tier will generate headlines, but even then it is accredited investors who are losing their investments. They understand the risks and rewards and that traditionally private equity generates solid returns. I have seen many successful PE exits and I know how disciplined certain managers can be about deploying capital, including with leverage. Sometimes you win, sometimes you win big, sometimes you lose and sometimes you lose big. Welcome to investing. However, to suggest that PE managers are investing similar to Softbank in true WeWork fashion is a big stretch IMO. It also lumps all PE together, which is a mistake given the differences between small cap, middle market and big cap. I have seen PE take a beating on this site several times, and leading Democratic candidates basically want to regulate PE out of existence or at least transfer power from equity owners to employees. I find it to be very unfair to the industry but not surprising.
Wolf, this is my lane. When I start to see articles and politicians implying or directly advocating for additional regulations for something they either mischaracterize or know little about, it directly threatens my livelihood. PE is doing just fine and should be left in the hands of its private owners.