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Episode 14 | David Rubenstein
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This Week on Wall Street
Global markets tumble on commodities, China, earnings
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Nearly every equity market around the world declined this week, weighed down by falling commodity prices, weak Chinese economic data and mediocre US corporate earnings. US indexes gave back all of last week’s healthy gains, with the S&P 500 falling 2.2%, not to be outdone by the Nasdaq and Dow, which tumbled 2.3% and 2.9%, respectively. The Dow and S&P have made several new all-time highs this year, but been unable to sustain any significant momentum and sit basically unchanged since Thanksgiving.
Oil prices continued to fall, with WTI crude futures dropping nearly 5% to $48.45/barrel, more than 20% off June highs. Gold also saw heavy selling this week, falling around 4.0% to hit a five-year low below $1,000/ounce.
Amid weakness in global equities, investors flocked to safe-haven US treasuries and German bunds, with yields on the 10-year bonds falling to 2.26% and 0.66%, respectively. The yield curve flattened as the 2-year treasury yield ticked up 0.1% while the 10-year and 30-year yield fell 0.08% and 0.12%, respectively. Credit spreads also widened as high yield bonds sold off.
Earnings
Earnings season so far has produced a stark dichotomy of winners and losers, with disappointment being the prevailing sentiment this week, the busiest of the quarter. While 75% of reporting companies have topped earnings-per-share estimates, top-line revenue growth has been lackluster with only 52% topping expectations, according to FactSet.
Apple (AAPL) set the bearish tone with a mediocre report as the company is in between iPhone cycles. The company, known for issuing conservative guidance, actually exceeded estimates but not by enough to push the stock higher. AAPL tumbled as much as 7% in the immediate aftermath of the report, but pared losses to finish the week down around 5% after gaining nearly 10% in the previous two weeks. Given AAPL is the most heavily weighted component of both the S&P 500 and Nasdaq, its weakness contributed heavily to the indexes’ weekly decline.
Microsoft (MSFT) sold off after the company reported a record $3.2 billion loss for the quarter thanks to an $8.4 billion charge related to the mobile phone division, which was acquired from Nokia in 2014. Excluding the write-down, Microsoft’s earnings actually topped estimates.
Dow components IBM (IBM), Caterpillar (CAT) and 3M (MMM) also reported disappointing earnings, finishing the week down around 7%, 8% and 5%, respectively. IBM reported its 13th straight annualized decline in quarterly revenue.
However, those losses paled in comparison the beating put on Biogen Idec (BIIB), highlighting the sometimes-fickle nature of biotech stocks. BIIB, one of the five largest components in the Biotech ETF (IBB) plummeted 22% on Friday after cutting 2015 guidance due to soft demand for its multiple sclerosis drug TECFIDERA. The shellacking spilled over into the rest of the biotech sector as IBB fell 4% Friday.
Chipotle (CMG) continued to defy gravity, initially declining on what looked on the surface like a weak report, but bouncing back during the conference call as analysts dug further into the numbers.
AT&T (T) and Verizon (VZ) beat earnings expectations for the quarter, but while Verizon’s stock price dropped, AT&T's jumped.
Amazon (AMZN) emerged as the week’s big winner. The company has made a habit of heavily re-investing revenue, often to the chagrin of value investing advocates, and despite a lack of net income investors have remained patient. This week, Amazon’s focus on long-term growth was vindicated as the company reported 25.5% annual increase in sales, leading to a surprisingly large profit and sending the stock sharply higher. The stock was up more than 20% immediately following the report, although it pared half of gains during the session Friday.
Starbucks (SBUX) stock followed a similar spike-then-fade pattern after a strong report, while Visa (V) also rallied on better-than-expected numbers. Morgan Stanley (MS) shrugged off the weight of financial regulation that has stifled trading profits at fellow banks, as a 32% increase in trading revenue helped the company top expectations.
M&A
Consolidation in the healthcare industry continues as Anthem has agreed to buy fellow health insurer rival Cigna for $48.4 billion, a 22% premium above the latter’s closing price on Thursday. If the deal goes through it would create the largest health insurance company in the US.
Lockheed Martin consolidated its position as the Pentagon’s top supplier by agreeing a deal to buy helicopter producer Sikorsky Aircraft, a unit of United Technologies, for $9 billion.
Europe
Greece’s parliament passed new austerity measures Thursday, paving the way for a third bailout package worth €86 billion to kick in before a €3.2 billion payment to the European Central Bank (ECB) is due August 20. While the fragile Greek banking system reopened Monday following a three-week closure, capital controls are still in place. Greek financial markets remained closed.
Asia
Flash PMI survey results out of China hit a 15-month low, falling from 49.4 in June to 48.2 in July to trigger selling in Asian markets. The report indicates the economic slowdown in China is worsening, putting pressure on Chinese officials to ponder additional stimulus measures.
The value of Japanese exports rose nearly 10% from the year-ago period, while the International Monetary Fund (IMF) warned that unless Japan enacts budget cuts, its runaway debt could balloon to three times GDP by 2030.
US economic data
Existing Home Sales, which account for roughly 90% of all home sales, hit their highest level since February 2007, rising 9.6% year-over-year to 5.5 million units. New Home Sales for June disappointed with a 6.8% decline to 482,000 units, but that figure still represented a more than 18% annual increase.
Thursday’s initial jobless claims report delivered one of the most bullish signs for the US economy since the start of the economic recovery began, with the 255,000 initial claims the lowest count since 1973.
The leading indicators index also came in stronger-than-expected, further indication the recovery is on track after a shaky start to the year.
Week ahead
- Monday: US durable goods orders, Germany’s Ifo survey
- Tuesday: Notable earnings - BP, DD, JBLU; TWTR
- Wednesday: US Federal Reserve policy decision. Notable earnings - CG, MA
- Thursday: US GDP, US jobless claims, EU economic sentiment. Notable earnings - PG, SNE; LNKD
- Friday: Notable earnings - XOM
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Episode Playback
David Rubenstein dishes on the state of private equity
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Did you miss Sunday's show featuring David Rubenstein? Watch all segments, extended interviews and web extras at WallStreetWeek.com
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Episode Feature
Unicorns evidence of mythological market forces
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Unicorns are mythological creatures, but in the fantasy land that is Silicon Valley, the fabled beasts are showing up with increasing regularity. In the investment context, “unicorn” is a term that describes a private company valued in excess of $1 billion. A decade ago, the idea of a $1 billion private company was almost unheard of, but today there are more than 100 roaming the landscape.
While companies historically would, if possible, choose to access the larger pool of capital available in public markets, today's private equity markets have grown to the point that companies are able to raise sufficient capital for growth, according to this week’s guest Wall Street Week guest David Rubenstein, co-founder and co-CEO of The Carlyle Group, one of the leading private equity firms in the world with around $200 billion of assets under management.
“In the old days, if a company had $1 billion market value in a private setting, it would go public right away,” Rubenstein said. “Now you don't need to do that because there's plenty of money going into these companies to give them capital to keep growing as a private company.”
The size of unicorns began to grow with the proliferation of social media companies. Facebook (FB) resisted overtures to go public until May 2012, at which time the company was valued on secondary private markets at more than $100 billion. Facebook became a unicorn in 2006 when it reportedly turned down a $1 billion offer from Yahoo! (YHOO). Twitter (TWTR) learned from Facebook, holding out before an eventual $14.2 billion IPO in November 2013. While Facebook got over its early public growing pains and now carries a market capitalization of around $270 billion, Twitter has yet to find its public sea legs, carrying a valuation around $24 billion.
By nature, unicorns typically emerge when a new technology or concept, that is initially hard to value, hits the market. Given high growth rates and likely early operating losses, private companies based on new technology carry tremendous potential. Even if a small percentage of private tech investments turn out profitable, one massively successful venture can lead to above average returns in a portfolio.
One of Carlyle’s most high-profile deals was their 2013 acquisition of a 31% stake in Beats by Dre. The deal valued the company at more than $1.5 billion, but only months later in 2014 the firm orchestrated a deal to sell the headphone company and streaming music service to Apple for around $3 billion – realizing a hefty return.
Today, many of the most glamorous unicorns are emerging within the context of the new sharing economy. Car on-demand service Uber is currently valued at around $50 billion. In June, Airbnb raised $1.5 billion at a valuation exceeding $25 billion. Both companies own very few assets, acting simply as technology platforms capable of unlocking excess capacity in our society in a new, value-added way. However, because of their disruptive nature both Uber and Airbnb face legal and regulatory hurdles they will need to navigate in order to justify sky-high earnings multiples.
In 2014 alone, 47 private companies became unicorns, more than the number of companies joining the club in 2012 and 2013 combined. The acceleration is continuing in 2015, which has seen 30 new unicorns spawned. With money pouring into Silicon Valley, the inevitable question becomes: are we in the midst of tech bubble 2.0? Broadly speaking, Rubenstein doesn’t believe so, but does think certain companies may be overvalued.
“I do think that probably the air will come out of some of the valuations. Now, there are some companies in the technology world that have changed the world. I think Uber is probably one of them. I think Airbnb is probably going to be one of them. But not every company that’s a technology company is Uber or Airbnb or Facebook. So the lesser companies get swept along. And at some point when the correction occurs, I think the values will come down in some of those companies.”
Online retailer Jet.com became a unicorn before making its first sale, reaching a $3 billion valuation prior to opening for business this week. The retailer officially launched on Tuesday promising members the cheapest prices on the Internet by 10-15%, making no bones about its strategy to take on Amazon (AMZN) with a Costco-like wholesale approach. Analysts project the company to operate at a loss for the next five years (thanks to their loss-leader approach), reinforcing Rubenstein’s notion that tech valuations are on the frothy side.
Desperate search for yield
The surge in the unicorn population is largely a byproduct of the desperate search for yield in today’s market, a phenomenon which has been covered at length on Wall Street Week. With US equity markets generally considered close to fully-valued and US treasuries delivering paltry coupons, investors have turned increasingly to riskier asset classes like junk bonds, distressed debt and private equity. Rubenstein also noted the industry over-crowding has caused several bidding wars among private equity firms. Carlyle, he said, is opening a new office in Silicon Valley in order to maintain competitiveness in technology-related private offerings.
As a result of investors' slide down the risk curve, returns for traditionally high-yield assets classes now occupy territory normally reserved for assets with lower risk profiles. Rubenstein believes decreased expectations for private equity returns have contributed to the industry’s rampant growth.
“There is a lot of money in private equity and that's because the returns have been very good. And so investors see that there's nothing better than private equity overall over the last five, ten, 15, 20 years. That's why there's a fair amount of money. And returns will probably come down, and have come down from the peak years. But even the returns that are coming down are still going be very good for investors.
So in the old days, 20 years ago, investors might want 25% annualized net internal rates of return. Today if you can get 16%, 17%, 18%, that's great too. So investors, their expectations have come down. And that's probably good. And that's fueled more money coming in because investors are happy with somewhat lower returns, which are somewhat easier to attain.”
While rich US equity and credit markets have triggered a stampede into high-yield assets, Rubenstein says the dearth of compelling investment opportunities extends into the private equity space as well. In addition to lofty private valuations, real estate prices have also been rising sharply in key markets.
This week’s guest co-host, Charles Schwab Chief Investment Strategiest Liz Ann Sonders, asked Rubenstein about the amount of dry powder, or capital raised that has not yet been deployed to buy assets, building up in private equity books. He said PE investors will likely continue to be patient until a market dislocation creates more attractive risk-reward scenarios.
“We've had high stock prices for a long time now. And until there's a market correction, it probably won't be the case that you can buy that many things. So private equity haven't bought a lot of things in the last year or so because prices are very high and we've been outbid by strategic [acquirers]. I do think when there's a market correction, which inevitably will come along, we will see private equity people be taking some this dry powder and deploying it in good ways.”
While private tech valuations are not terribly compelling at the moment, one pocket of the market that has become more compelling to private equity investors due to recent dislocations is energy. Rubenstein struck a more optimistic tone about opportunities within the energy sector.
“I think it's one of the greatest times in the world to invest in carbon-related energy… Because it's relatively cheap, for hundreds of years it will probably be here. Maybe in 50 or 100 years we'll have more renewables, but right now we're going to use [oil, gas and coal] for quite a while. Prices are relatively cheap… Of course, we recognize that carbon will affect the environment, and everybody should do something about climate change… But in the history of the world, it's rarely the case that people have willingly done things that will benefit their grandchildren but not them…
I do think that carbon-related energy is a pretty good investment. Obviously I think natural gas is probably going to be a cleaner form of energy than coal, and probably more money will go into that. And it's a good area to invest in. But as the world transitions from a world where the emerging markets are becoming more and more important, and they consume more and more energy, there's going be a lot of opportunity to invest there in exploration, production, storage, transmission, refining.”
Asset allocation is a labyrinth, with the path to outperformance constantly shifting under investors' feet. Distortions in one asset class create equal and opposite reactions across the investment landscape. The global investment habitat burned during the financial crisis, and policy makers doused financial markets with liquidity to extinguish the flames. The overgrowth of unicorns is part of Wall Street’s evolving secondary forest.
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Investment Primer
What is private equity (PE)?
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In Episode 14, David Rubenstein discusses private equity at length, so we put together a primer on the broad asset class.
What is private equity?
Private equity (PE) is an asset class consisting of equity and debt securities in companies that do not trade on public exchanges. By nature, private equity investments are less liquid than public securities because there is a less mature secondary market for private assets, although private markets have grown considerably in the last decade.
Private equity investments are considered to carry higher risk and higher reward potential because private companies have fewer reporting requirements than public companies. Because of the illiquidity of private assets, firms typically invest in private companies over longer time horizons.
Private equity investors use a number of strategies aimed at unlocking value in companies through restructuring or the provision of capital for growth. Investment firms may deploy capital toward a minority stake in a nascent, fast-growing company (venture capital) or seek a majority stake in a large company with mature cash flows (leveraged buyout). Private equity firms also participate in real estate and energy infrastructure investments.
What is a leveraged buyout?
Private equity is considered by some a re-branding of the controversial practice of leveraged buy-outs (LBO), although not all private equity investments fall under the LBO umbrella. LBOs involve an investment firm acquiring the majority stake in a company from shareholders through the use of leverage, or borrowed capital. Firms conducting LBOs use the acquired company’s cash flows as the collateral for a loan from a financial sponsor and to make principal and interest payments on the loan.
LBOs are attractive because the investor can gain control of a valuable asset without having to commit a large amount of capital, and returns can be augmented as long as income growth exceeds the interest rate on the loan. The amount of money a financial sponsor is willing to lend for an LBO depends on the amount of debt, growth and liquid assets held by the acquisition target. The debt portion of an LBO typically falls between 60-90% of the purchase price.
Firms are typically motivated to perform LBOs because they believe the acquisition target is undervalued. Much like activist investors, PE firms take a proactive role in restructuring companies to unlock value. By gaining a majority stake, the acquiring firm can then freely pursue changes to capital and operating structure, which can include splitting up the business. Private equity firms often conduct LBOs with the intention of ultimately bringing the company, or one of the newly off-spun entities, public again in the future.
What are venture and growth capital?
Venture capital is often considered its own asset class, but technically is a robust species within the private equity genus. VC involves providing capital to early-stage, high-growth companies in return for a minority equity stake. Companies receiving VC funding are typically involved in a new technology or marketing concept that requires a significant amount of capital before realizing mature cash-flows. VC investments are made in a series of rounds based on the growth stage of the company.
Because of the inherent risks of investing in fledgling companies, firms typically employ wide diversification in VC portfolios. Whereas one VC investment may turn into a zero, another could mature into a highly-successful company and deliver massive returns to early investors. Today, you see a number of private companies that carry valuations typically associated with public companies. Unicorns, private companies valued in excess of $1 billion, have become increasingly common.
Growth capital refers to investments in more mature private companies looking to make a significant expansion, acquisition or restructuring. PIPEs refer to private investments in public companies.
What is private equity distressed debt investing?
Private companies, like public companies, can raise capital by issuing equity or debt. Private equity firms may also invest in distressed companies drowning under the weight of large debt obligations, seeking to either rescue the company from the brink of bankruptcy or position themselves to control assets post-bankruptcy.
When a company’s ability to service its debt decreases due to a lack of growth, the owner of the debt – usually a bank – is forced to write down the initial value of that debt. In a default or bankruptcy, certain classes of debt investors sit at the top of the food chain to collect assets upon liquidation. Distressed debt investors simply seek to buy assets that have been written down for less than they are worth in a bankruptcy or rescue scenario.
Private equity considerations
A private equity firm will determine its preferred return, also known as a hurdle rate, on an investment, which represents the minimum annual return required to compensate for the related level of risk. After determining the preferred rate, the firm will look at a potential investment’s internal rate of return (IRR). This internal rate of return is based on a company’s projected cost of capital and cash flows. If the IRR is higher than the hurdle rate, then the private equity firm will choose to invest money to acquire the target company because the potential returns outweigh the risks. However, if the IRR is lower than the preferred rate, then the firm would likely not follow through with the acquisition because the risks are too high.
How can you invest in private equity?
Private equity funds are traditionally only open to investment from accredited investors, which are individuals with a net worth (not including the value of their primary residence) of more than $1 million or annual income for the past two years of greater than $250,000. However, endowments, retirement plans, and institutional funds are now increasingly investing pooled assets directly into private equity firms in search of higher returns.
Feeder funds are a growing outlet for individuals who are interested in investing in private equity firms. These funds pool assets from a group of individual investors and invest them into a master fund. The master fund then invests in a diversified portfolio of private equity firms, hedging the risk an investor faces from investing in a single private equity firm.
Have more questions about private equity? Email us at prosper@wallstreetweek.com
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Week Links
Haves and have nots
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Economy
Signals Flashing Green for U.S. Economy as 2015 Road Clears (Bloomberg, Michelle Jamrisko)
Beware the Fed on the ides of September (FT, Gavyn Davies)
Asia
Trade vote puts Michael Froman on faster track (Politico, Doug Palmer)
China’s looming stock market disaster is part 1929 America, part 1989 Japan (Quartz, Gwynn Guilford)
Europe
How Can Greece Take Charge? (New Yorker, James Surowiecki)
Europeans feel a little better about the economy (Politico, Antoine Sander)
Middle East
Iran Deal Could Help U.S. Tech Recruiters (WSJ, Robert McMillan)
Iran eyes $185 billion oil and gas projects after sanctions (Reuters, Shadia Nasralla and Maria Sheahan)
Markets
How Wall Street makes its money now, in one chart (Fortune, Stephen Gandel and Stacy Jones)
Nasdaq Expects to Be First Exchange Using Bitcoin Technology (Bloomberg, John Detrixhe and Ryan Hoerger)
Unicorns
Frenzy Around Shopping Site Jet.com Harks Back to Dot-Com Boom (WSJ, Rolfe Winkler)
Uber should savor its New York win—because it may be paying for the subway before long (Quartz, Tim Fernholz)
Asset management
Asset allocation: Make it personal (Vanguard Blog, Chuck Riley)
Market timing with Value and Momentum (Alpha Architect, Jack Vogel)
Potpourri
Japanese publisher Nikkei to buy Financial Times (USA Today, Roger Yu and Nathan Bomey)
Here’s what your stolen identity goes for on the internet’s black market (Quartz, Keith Collins)
Hackers Remotely Kill A Jeep On The Highway—With Me In It (Wired, Andy Greenberg)
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