Don’t look back in anger
Back in 2000, there were about 2,000 registered private equity firms globally. Twenty years later and that number has now hit 10,000. It’s a five-fold increase reflecting a boom in Private Equity investing by endowments, sovereign funds and the wealthy.
Remembering the very same investors previously lost fortunes investing with Commodity Trading Advisers (CTAs), followed then by hedge funds, and finally subprime loans. A valid question is whether this fad has become a dangerous bubble with contagion-like consequences for mere mortals.
Various theories exist to explain why Private Equity has become so popular. Perhaps the most interesting is that after the GFC, institutional investors sought to eschew the daily mark-to-market volatility that accompanies public markets, in favour of the smooth (and leveraged) equity curve displayed when private companies raise money at magically increasing valuations.
But in reality, the most likely explanation is the same one that explains ultra-high prices for all asset classes – declining interest rates. As interest rate cuts have malformed cash from an asset to a liability, they have also forced investors to seek greater returns elsewhere. And as interest rates globally headed to zero, and below, so the prospect of a ten-bagger by investing in a start-up, on the ground floor, became much more appealing.
The risk of investing in a start-up is very high. Indeed, it has always been thus. Of the many thousands of businesses launched, only a few become successful and a precious fraction of that become household names. The probability of hitting on a winner through private equity ought to be very low.
Thanks to low interest rates however, success in private equity investing has become easy. Too easy. In the last decade all investors have had to do is continue to throw money at scaling an idea that disrupts an incumbent business model reliant on the archaic principle of making profits. Disrupt that incumbent’s profits, make none yourself, destroy the equity in both businesses and then float yours on the stock market by selling your shares to an unsuspecting public. Easy.
Searching for unicorns
With so many start-ups becoming unicorns over the last ten years without the expectation of, or requirement to, make profits, and with some of those unicorns becoming Amazons, Facebooks and Googles, investors threw caution to the wind. University endowments swapped their love of active equity managers and hedge funds for Private Equity. High Net Worth and Ultra High Net Worth investors followed suit.
Private Equity should be considered only for a very small part of any portfolio and yet the Yale Endowment Fund has 40 per cent of its assets allocated to private equity, while Australia’s own Future Fund has a reported 16 per cent of its $160 billion in private equity.
No doubt the advertised returns have helped their popularity in portfolios but none other than Warren Buffet has called out the accounting practices adopted by Private Equity Funds to calculate their advertised returns noting; “We have seen a number of proposals from private equity funds where the returns are really not calculated in a manner that I would regard as honest.”
What about liquidity?
The issue for those heavily invested in private equity is a combination of extreme valuations, a lack of profit, a rapidly closing IPO window and virtually no liquidity.
When an asset is highly liquid it should command a premium to an asset that is less liquid. But the reverse is true in private equity. According to the World Bank and Prequin, since 2002 US public Equity markets have increased their market capitalisation 3.5-fold. In the same amount of time, and thanks to the aforementioned five-fold increase in the number of Private Equity ‘helpers’, the net asset value of companies held by private equity has increased eight-fold! And keep in mind public markets are at stretched valuations. How overstretched must private company valuations be?
This looks like a classic ‘crowded’ trade. The world’s endowments funds, super funds, high net worth and ultra-high-net worth investors are up to their gills in illiquid, profitless, private equity-owned ‘businesses’. And thanks to the collapse of WeWork and the 41 per cent decline in the share price of Lyft since listing the IPO window for exiting is rapidly closing. And to top it off, the number of listed companies in the US has halved from almost 8000 to less than 4000 today.
I remember investing during the GFC when many funds performed poorly and closed to redemptions leaving their clients unable to access cash. When illiquidity hit poorly performing funds, investors desperate to pull cash from risky assets turned to the funds doing well.
I can’t help but wonder whether high net worth investors heavily committed to illiquid private equity funds turn to the stock market to raise cash when they realise the companies they own will never make a profit and exiting via an IPO has just become a pipe dream. If the appetite for risk evaporates in private equity, current public market euphoria might just evaporate too.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
