Market Thinking

making sense of the narrative

Where are the Customers’ jets?

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We have been talking about Private Equity since the early days of this blog, but more recently here and here, where we asked an update to the famous Fred Schwed question “Where are all the (Private Equity) Customers’ Private jets? This came to mind once more as the always interesting Robin Wigglesworth produced some good stats last Friday in the FT in a piece on Private Capital, which, along with ESG, is seen as the magic bullet by large Investment Houses, offering the prospect of fat fees and none of that pesky pressure to actually perform. Private Equity, Private Credit, Private Debt. Private Markets = Private Jets.

Private capital industry has exploded in size
Source FT

In this of course they are assisted by the Pension Fund and Insurance company ‘gatekeepers’, the Consultants, whose universe of risk appears limited to a) Volatility and b) Correlation with broad equity indices. As such, the fact that the Private markets barely trade is then a perfect situation for pension funds and insurance companies while also being an exemplar of the Principal/agent problem. The trustee or insurance CIO can not be blamed for buying these officially deemed ‘low risk assets’, indeed it is now essentially required of them. Their job is only to try and pick ‘the best’ ones – even if, sadly, that means paying the sort of eye-watering fees that they would not dream of contemplating paying anyone in public markets. The fact that, after allowing for a lack of liquidity and high fees, the returns are lacklustre at best (the majority having been taken by the managers) is not their problem.

The FT article highlighted in particular the excitement the managers have over so called ‘Growth Equity’ as an asset class. As a tip, when managers and promoters get excited about an asset class it is rarely because they believe the customers will be doing particularly well out of it. This of course is the impact of that well known handmaiden of principal/agent, Producer capture. These products are for the benefit of the producer, not the consumer. The plan here is that rather than allowing small companies to float on public markets and thus raise capital to expand, the Private Equity/Growth Equity funds will come in and provide that capital themselves using third party investors’ capital while taking a hefty fee for managing the fund. The great thing about this from the Private Equity/agent’s perspective is that the capital is tied up for, perhaps, 7 years, thus guaranteeing an annuity income until the (delayed) IPO. At this point, the funds will take a performance fee (likely in a tax efficient – for them – carry structure) as a reward for the illiquidity premium that the investor has suffered as well as the inflation and general market linked return.

It’s rather like you want to buy a house at what you think is a below market price, but the agent tells you it is much better that you give him the money today and he will buy it for you and rent it out, but charge you a big annual fee for doing so, while the rent itself goes to pay the interest on the debt you apparently took on. Then after 7 years he sells it for you, through his friendly estate agent obviously, who also charges a fat fee while the agent himself now gets 20% of your capital gain – including on the leverage that you paid for. Even better for them if they sell another, new, fund that they also manage, where a new set of investors are offered ‘a golden opportunity’. And so it goes on.

Ironically, the housing analogy might in fact work as a strategy if it allowed for diversification and avoidance of various tax structures, but in the real world. the Growth Equity structure is mainly about exploiting the desire of long term ‘investors’ to avoid blame for underperforming a benchmark. It’s the same mindset that meant the England Cricket Team avoided chasing a win against New Zealand at Lords last week or that means the UK government continues to lockdown the economy in case there is a resurgence in Covid cases. Avoiding blame is a powerful motivation for many people. Fear, not greed. Of course in this instance there is plenty of greed about too.

Reading below the line comments is always useful, particularly in the FT which has so far avoided a lot of the ‘guns and gold’ ramblings of a lot of financial sites and one of the comments (from a poster named simply ‘B’ sums the situation up perfectly:

“So as a Pension Fund Manager with billions to invest from the retirement savings of thousands of little folks, let me put some more money into opaque illiquid assets with no market and entirely subjective valuations done infrequently and no means of knowing if the invested funds are doing well or if they have evaporated in a haze. So long as I get a solemn assurance from the Private capital Operator that all is well and better still get an occasional update once or twice a year with a hypothetical no-commitment valuation showing a strong theoretical return, all is well and jolly. Where is the dotted line on which I need to sign ?  And the Regulators – behind the curve as usual ?

B. Commenting Below the line in ft article

Ultimately, you only take a company private if you think the public market is paying too little for it and, mostly, you only take it public if you think the public will pay too much for it. Both are currently easier than ever, with the seemingly limitless amounts of financial leverage available to pile on the top of money that has been told these strategies carry no other risk. As ever, the financial sector is inserting itself into the market place to drive turnover between the two while booking fees and extracting rent/carry along the way. Like any boom, it’s probably best to keep buying the guys selling the picks and shovels – brokers and Private Equity firms as you know they are going to win, whatever happens to the underlying investment.

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