Liquefaction
Portico Perspectives (October 2018)
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Liquefaction| ˌlikwəˈfakSH(ə)n | noun
a process that creates a liquid from a solid (basically)
I’ve been wrestling with the idea of entropy in international affairs for the last five years or so. During my travels to London a couple weeks ago, Brexit peppered most every conversation, and I found myself thinking about political instability and its implications for investors.
The global landscape has transformed from solid to fluid, whether at the level of the international system, the state, or the individual. While the “decline of the liberal international order” has been debated ad nauseum, it’s fairly clear that we are transitioning from the post-World War II system to a new one. The problems seem to be that: (1) nobody knows what the new system should be; and, (2) no leaders are guiding us toward one.
That may be due to the fact that national leaders have more pressing priorities. How are leaders meant to identify principles of unity amongst nations when disunity and discord are ascendant at home — and, indeed, actively stoked to win at the polls?
Our populist and reactionary politics are a symptom, not the disease. At bottom, across developed and emerging markets alike, the social contract is broken.
As bleak as things are, it’s worth remembering that one of the benefits of democratic governance is that these fissures are out in the open. People are free to talk about them. The steam can be released. Society and institutions can adapt.
So, amidst all this political instability I’m beginning to think that the greatest risks in this brave new world come from the presumption of stability where none, in fact, exists.
And while I'm at it, I detect an astonishing degree of complacency toward one market in particular: China.
According to EMPEA’s Industry Statistics, $84B of capital has been raised for China-dedicated PE funds over the last five-and-a-half years, with scores of billions in regional funds that will invest in the country.
There seems to be a presumption that, since the country and its currency have been stable, this state of affairs will continue. That’s not how things work. Everyone’s legal disclaimers say as much (“Past performance is not indicative of future results …”).
I shared my rule #1 on China last month (“nobody knows anything about China — especially me”), but China’s fragilities are increasing. And a certain someone in the White House seems to smell it.
Will the country’s political system be able to respond to current and future challenges? In a manner that’s aligned with the interests of international capital?
I have my doubts.
At the very least, confidence intervals should be adjusted.
My conclusion: the most valuable attribute in EM private markets going forward is a flexible mandate.
There will always be a place for focused specialists, especially managers who bring bona fide operational expertise and can genuinely build businesses. However, in a fluid global landscape, flexibility is key — whether geographic, along the capital stack, or even across asset classes.
It’s time to think different.
Anyway, Portico has been busy in all corners during this harvest season, but particularly in Latin America, which remains a manifestly underappreciated region (see below).
Things are also a tad hectic on a personal level, as our family’s expecting the arrival of our second son / first little brother next month. If there’s no newsletter in November, well … entropy.
Alla prossima,
Mike
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Herd Behavior
EMPEA released its 1H 2018 industry statistics and the concentration of capital in Emerging Asia is astonishing. Across private equity strategies (i.e., buyout, growth, and VC) Emerging Asia captured $24B — 93%! — of EM fundraising in the first six months of the year (that’s up from 77% in full-year 2015).
Only $1.85B was earmarked for PE managers active in Africa, Central & Eastern Europe, Latin America, and Pan-EM.
As usual, it’s worse than it appears.
That $1.85B figure overstates the volume of U.S. dollar investors committing capital to EM managers. Consider that the largest PE funds achieving a close in each region ex-Asia raised only $382m in USD, but $1.1B in local currency vehicles (see below).
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I get that political uncertainty has stalled many Latin American managers’ fundraising plans, but $24m in USD? WTF?
Meanwhile, the forward calendar in Emerging Asia (inclusive of closes in Q3) has over $50B of USD-denominated funds in market (e.g., Hillhouse, Baring Asia, CVC, PAG, TPG, etc.).
I’ve disclosed Portico’s interest, but if ever there were a contrarian play in EM PE …
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KYC
Fred Wilson of Union Square Ventures put out a heat-seeking missile of a blog post on Sunday (Who Are My Investors?). You should read it.
Fred’s musings were prompted by a note from one of USV’s portfolio company CEOs, who said:
I need to know if any of your LPs include ………. entities/interests.
This is a super interesting and welcome development, and I think Fred’s right to conclude that the quality of a fund’s LPs will impact deal flow … at least in U.S. venture.
A few quick reactions:
- The cynic in me wonders if this sentiment is a luxury of a world awash in capital. But then, maybe founders with vision are the scarcest thing around.
- For all the asset managers clamoring after Millennial money with impact strategies, it’s notable that founders are saying they want to partner with ethical investors who share their values.
- We’ve talked a lot about transparency and governance in this newsletter this year, and it’s intriguing to see a dialogue emerge about information flowing down to the portfolio company, and not just up to the fund.
Anyway, in case you don’t click through to Fred’s post, his bold conclusion follows:
It is time for all of us in the startup and VC sector to do a deep dive on our investor base and ask the question that the CEO asked me. Who are our investors and can we be proud of them? And do we want to work for them?
…
Not all money is the same. The people that come with it and who are behind it matter. That has always been the case and remains the case and we are reminded of it from time to time. Like right now.
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Add-Backs
The thing about dealing with leveraged buyout firms is that you always know who the Muppet isn’t.
Let’s say you’re a leveraged lender. A Patrick Bateman clone shows up and presents his bone-colored business card along with pro forma financials showing “adjusted EBITDA” for a company they’d like to lever at 6x.
You ask some questions about his revenue growth and efficiency gain assumptions, which seem slightly … optimistic.
But also, you don’t want to get fired for turning away business from a Very Important Client Who Always Gets What He Wants.
Meh, it’s not your money.
So the loan gets funded, and some teachers’ pension in Dubuque or wherever ends up holding the paper.
A couple years later, as you’re clearing out your desk, you find Bateman’s business card and you remember the discussions about the adjusted EBITDA. And since you’ve just been fired, you have time to look up what happened to that company. Did they grow revenues? Did they capture those efficiencies?
If your research reveals anything like a recent analysis by S&P Global Ratings, you’re likely to find that Bateman’s adjusted EBITDA turned out to be slightly … optimistic.
Says Institutional Investor:
In an analysis of companies involved in deal making in 2015, S&P found that the earnings projections were unrealistically high on average across leveraged buyouts and mergers due to so-called “add-backs” — adjustments made to account for expected cost savings or an anticipated rise in revenue … Compared to companies’ projections, EBITDA … turned out to be 29 percent lower in 2016 and 34 percent lower last year.
The good news is: (1) tallboys of Tecate come with a shot of Fidencio at El Rey’s tonight; and, (2) your mom’s pension invested in the LBO fund.
So when Bateman & Co. jammed through the inevitable dividend recap, the probability of your mom living on cat food declined by a few basis points. Unlike those sad souls in Des Moines or wherever.
Every cloud has a silver lining.
¡Salud!
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Public Companies and Short-Termism
The U.S. Federal Reserve Board conducted a study to investigate the investment tendencies of public and private firms. Using corporate tax returns, the economists determined that — contrary to popular belief — “public firms invest substantially more than private firms.”
Says the study:
Relative to physical assets, publicly-listed firms invest approximately 48.1 percentage points more than privately-held firms … predominantly driven by long-term assets: public firms invest 6.5 percentage points more in short-term assets, and 46.1 percentage points more in long-term assets than their private firm counterparts … The access to capital investment and the ability to spread risks among many small shareholders appears to facilitate heavier investments in R&D, arguably the riskiest of asset classes.
You learn something every day.
And who knew R&D was an asset class?
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Impact Investing
I don’t know about you, but I find it a bit difficult to wrap my head around “impact investing.” The term is as slippery as a greased pig.
IFC has stepped into the breach and developed, in consultation with asset managers and investors, a set of Operating Principles for Impact Management. The draft document establishes nine principles across the following five elements:
- Strategic Intent
- Origination & Structuring
- Portfolio Management
- Impact at Exit
- Independent Verification
IFC is inviting reviews from stakeholders through the end of the year, so if you have an opinion, please share it. With IFC.
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From the Bookshelf
Thus they were able to recall the past in the hope of finding new wisdom rather than in awe of its immutable commands; they could think of the future as a time of promise rather than of certainty; and they could use the present as an opportunity for the exercise of choices rather than for compliance with preordained patterns of life.
— Adda Bozeman, Politics and Culture in International History
(Princeton University Press: 1960)
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About Portico
Portico Advisers serves private capital practitioners active in Africa, Asia, Eastern Europe, and Latin America.
We partner with fund managers to pinpoint their value proposition, enhance their market positioning, and produce institutional-quality pitchbooks and PPMs.
We also undertake custom research studies for institutional investors, and select stakeholders in the public and social sectors.
We are dedicated to closing the finance gap through the creation and dissemination of knowledge.
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The information presented in this newsletter is for informational purposes only. Portico Advisers does not undertake to update this material and the opinions and conclusions contained herein may change without notice. Portico Advisers does not make any warranty that the information in this newsletter is error-free, omission-free, complete, accurate, or reliable. Nothing contained in this newsletter should be construed as legal, tax, securities, or investment advice.
Copyright © by Portico Advisers, LLC 2018, all rights reserved.
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