Private Equity's Minsky Moment?

Luis Garcia of private Equity News reports that indexes show private equity valuations suffering more than venture capital’s:
Private markets investors face a major challenge these days: How to evaluate the impact of coronavirus-driven economic disruptions on their holdings.

A pair of indexes suggest that private equity portfolios may be suffering more than those held by venture capital firms.

The Thomson Reuters Private Equity Buyout Index, which tracks the performance of private equity funds, as of Thursday had lost 24% so far this year.

By comparison, the Thomson Reuters Venture Capital Index had dropped 4.1% in the same period. The latter index serves as a proxy for venture capital fund returns.

“The indices are designed to provide an indication of what the general valuation change is for the private equity or venture capital space,” said Arthur Bushonville, co-founder and chief executive of DSC Quantitative Group, a Chicago-based investment firm that helped develop the indexes. "We think they’re very indicative of the change in valuation overall for those two asset classes."

The private equity index is derived from a selection of publicly traded securities used to replicate the returns of thousands of portfolio companies backed by sponsor funds, based on a DSC model. The companies in that model are picked from databases maintained by Refinitiv, a Thomson Reuters financial unit. The venture capital index tracks the performance of VC-backed companies, also using a selection of publicly traded assets.

DSC constructed the indexes working with the Thomson Reuters unit and began marketing them in 2014.

The diverging performance of the proprietary indexes reflects the differing overall composition of holdings by the two types of private market investment vehicles, with venture funds often backing comparatively more companies that are less affected by the pandemic, Bushonville said.

He said the venture capital index “is highly concentrated on technology and health care, and those are two of the best performing sectors…we’ve seen in the market over the last month or so”.

For example, technology investments accounted for 78% of the venture capital index when the year began, compared with 32% of the private equity index. On the other hand, the utilities and energy sector, where oil-related companies have been hammered as lockdowns erase demand for fuel, made up 7% of the private equity index and 0.3% of the venture capital barometer.

Venture capital’s focus on innovation could also help shore up portfolio value during the pandemic, as businesses developing new products have a better chance of remaining attractive to investors, said Jeff Knupp, DSC’s president. He cited the $600m in funding received earlier this month by payment processor Stripe, as one example.

“We’ve seen the private equity side pull back as we would have anticipated,” Knupp said. “We would have thought maybe VC would go down similarly, but it’s really held up very well.”
If you ask me, venture capital is outperforming because the NASDAQ is outperforming but once this party in equities stops and reverses, VC indexes will get clobbered.

Still, this is good news for VC and I did notice Omers Ventures, the venture capital arm of OMERS, just launched a $750m fund to back early-stage technology companies.

As far as private equity, there's no doubt, it's getting clobbered this year.

Over the weekend, Malcolm Hamilton sent me Matt Stoller's comment on Private Equity's Minksly Moment.

I read it, it was long so let me quote the section on the coronavirus crisis which is the crux of it:
All of this brings me to the current crisis in the industry. Last week, I went into why doctor staffing companies, owned by Blackstone and KKR, are cutting pay in a pandemic. But there’s more pain that private equity is dishing out; Axios reported that Staples, the private equity-owned office retailing chain, is stiffing landlords and refusing to pay rent on its stores, as is private equity-owned Petco (by CVC Capital Partners). Meanwhile a different private equity owned pet chain, Petsmart, is refusing to close its dog grooming salons and giving talking points to its employees misconstruing the law.

What’s interesting here is not just the use of power to extract concessions, but something else. Desperation. Petsmart is basically telling its employees to mislead law enforcement, and Staples is stiffing landlords (though one wonders if Staples is still paying rent to Sycamore for its headquarters). This isn’t normal. Indeed, something is wrong in private equity land. One of the biggest, and oldest, private equity firms, Kohlberg Kravis Roberts, or KKR, with hundreds of billions of dollars under management just warned investors that its business is in trouble.

Part of the risk here is what every company is experiencing, which is a depression. KKR told investors that its asset values “are generally correlated to the performance of the relevant equity and debt markets.” Some portfolio companies, the Wall Street Journal reported, “in sectors such as health care, travel, entertainment, senior living and retail could become insolvent if the disruptions from the pandemic and measures taken to stem them such as business shutdowns it aren’t ended.”

This is obviously true throughout the space, with a host of private equity companies whose investments have obviously evaporated; Vista Equity Partners paid $1.9 billion for yoga studio software company MindBody, and Bain Capital bought cheerleading monopoly Varsity in 2018 for $2.5 billion. Both companies are engaged in layoffs, and are in trouble.

And this gets to the much more serious problem that PE is having with this coronavirus crisis, which is potential trouble with the engine that makes the whole thing run, or borrowers. As KKR put it to investors recently, “We and our funds may experience similar difficulties, and certain funds have been subject to margin calls when the value of securities that collateralize their margin loan decreased substantially.”

Many of their portfolio companies were leveraged up with debt to increase returns, but the downside of leverage is that it magnifies losses. Envision, the KKR-owned doctor staffing firm, just hired an investment bank to find a way to renegotiating its massive $7.5 billion debt load; portions of its loans are trading are trading at 60 cents on the dollar. A company that can’t pay back its loans is bankrupt. And while Staples hasn’t defaulted on its debt, it is defaulting to creditors when it stopped paying rent. (I asked Sycamore if they have revalued Staples, but I didn’t get an answer.)

Between the 2008 financial crisis and the pandemic, it had been smooth sailing for private equity firms, who had in turn gotten more and more aggressive. Pension fund investors have thrown more money at PE firms, and debt investors, hungry for anything with a return, have also gotten more hungry for higher yields. PE firms have even launched their own debt funds, meaning that they are both borrowing money to buy firms and lending money to support takeovers. Basically, there’s now an entire shadow banking system of private equity giants and their various captive institutions lending and borrowing from each other, and buying and selling each others’ companies.

As they passed firms to one another, took them public and bring them private, loaded them up with debt and then more debt, it meant that the price of firms had been steadily going up. As a result, as Daniel Rasmussen & Greg Obenshain reported in their excellent article published just before the crisis in Institutional Investor magazine, PE funds are paying higher prices for firms with less cash flow, even as loan quality has deteriorated.

Private equity is undergoing what the great theorist Hyman Minsky pointed out is the Ponzi stage of the credit cycle in capitalist financial systems. This is the final stage before a blow-up. As Minsky observed, a period of placidity starts with firms borrowing money but being able to cover their borrowing with cash flow. Eventually, there’s more risk-taking until there’s a speculative frenzy, and firms can’t cover their debts with cash flow. They keep rolling over loans, and just hope that their assets keep going up in value so that they can sell assets to cover loans if necessary. To give an analogy, in 2006, when people in Las Vegas were flipping homes with no income, assuming that home values always went up, that was the Ponzi stage.

Now, what happens with Ponzi financing is that at some point, nicknamed a “Minsky Moment,” the bubble pops, and there’s mass distress as asset values fall and credit is withdrawn. Selling assets isn’t enough to pay back loans, because asset prices have collapsed and there’s not enough cash flow to service the debt. Mass bankruptcies or bailouts, which are really both a restructuring of capital structures, are the result.

I think you can see where I’m going with this. PE portfolio companies are heavily indebted, and they aren’t generating enough cash to service debts. The steady increase in asset values since 2009 has enabled funds to make tremendous gains because of the use of borrowed money. But now they are exposed to tremendous losses should there be any sort of disruption. And oh has this ever been a disruption. The coronavirus has exposed the entire sector.
Kind of harsh but there's a lot of truth in what he's saying, the old PE model of borrowing cheaply to buy out companies and restructure them is in peril and this coronavirus crisis has exposed that model for what it is -- an accident waiting to happen.

A lot of the portfolio companies private equity bought using cheap debt are simply not sustainable in a "no revenue" world and their losses will be magnified as this crisis plays out.

On Friday, I went over how the Neiman Marcus bankruptcy will sting CPPIB and OMERS.

This morning, I spoke to a former senior pension manager who told me that CPPIB will lose its equity stake on this acquisition:
 "I don't know if it's $500 million or $750 million or more, but that will be wiped once Neiman files for bankruptcy and creditors get first liens on assets. CPPIB can absorb these losses and might have already taken a writedown on Nieman as it was in trouble for a long time. However, they did another deal with Ares back in 2013 acquiring 99 Cents Only stores that was valued at US $1.6 billion. Not sure how well that is going."
That same person told me that most deals in private markets at large Canadian pensions are debt financed, meaning they typically put 30% in equity and finance the rest by borrowing (it varies depending on the deal, I am giving you an average).

"What this means is when there is a major downturn and revenues are hit, losses are magnified."

Empty airports, malls, office towers, and private companies going bankrupt don't bode well for private markets.

“Sadly, some of our companies won’t make it, it’s just a fact,” OMERS incoming CEO Blake Hutcheson recently stated. “Some of our private equity investments won’t make it, in real estate, some will take months to come back, some will take years.”

How all this plays out in private equity depends on this virus plays out but I am afraid people continue to underestimate the duration of the pandemic and overestimate what will happen when the economy reopens:

By my estimate, peak bankruptcies will hit the US economy this fall, long after the economy reopens. It won't be pretty and it will impact public and private markets.

Having said all this, I do remind my readers that Canadian pensions (and all pensions) have a very long investment horizon and are investing for the long run.

Many companies will go under, their private market portfolios will get hit, but this doesn't mean they should abandon private markets altogether. That's simply nonsense and would be a violation of their fiduciary duty to diversify across public and private markets all over the world.

Below, Jon Gray, president and chief operating officer of Blackstone Group, joined “Squawk Box” late last week to discuss the company’s quarterly earnings as well future investments, market recovery from the coronavirus crisis, the Fed’s policy measures to prop up the economy and more.

Listen carefully to what he says about writing down assets and waiting for a recovery. Interestingly, Blackstone sees distressed opportunities arising gradually over the next year, and they remain very disciplined in putting money out. Great insights, take the time to watch this.

Update: After reading this comment, Wayne Kozun, former SVP at OTPP and CIO of Forthlane Partners, shared this with me:
You're right about why the VC index is outperforming. Those Thomson Reuters Indexes are really just levered plays on Indexes. The VC index has a beta of 1.44 vs the Nasdaq 100 with an R^2 of 0.933. The PE index has a beta of 1.64 and an R^2 of 0.96 vs the S&P500. The Nasdaq has outperformed the S&P500 and the beta is lower.

The Nasdaq is outperforming thanks to trillion dollar stocks like Microsoft and Amazon. Those stocks will be faring way better than VC, with a very few exceptions.

Here is the Bloomberg BETA analysis for both of the Thomson Reuters indexes.

I thank Wayne for his insights and analysis, always appreciated.