I have a feeling that the next few years will be a golden age for active management as PE aggressively disgorges tarnished assets back into the public markets often at pennies on the dollar. For active portfolio managers, this will be the sort of thing that fortunes are made of.
For the better part of a decade, institutional investors have redeemed capital from active strategies and dumped it into Private Equity (PE).
What’s the benefit of PE for allocators?
You get to have levered equity returns without the volatility of actually owning public equities. Unlike stocks that often fluctuate wildly, PE is marked-to-model (M-T-M), hence quarterly volatility is minimal.
Then, when there’s a liquidity event, you get to see how well you did.
Or at least, that was the theory.
However, by the time of the liquidity event, usually someone else is in charge of the position.
Meanwhile, you’ve used the nice smooth M-T-M to earn yourself a bunch of bonuses and maybe even a promotion to somewhere else that’s ring-fenced from your allocation decisions at your prior job.
In many ways, the funds and the allocators themselves are both incentivized to mark the numbers higher and hope that they’re proven right.
Over the past year, I have been highly critical of the Ponzi Sector.
You have businesses with no hope of ever showing profits, focused on using VC capital to create revenue growth in the hope of an IPO.
As the IPO window has now closed, these companies are in something of a bind; if they slow growth to reduce losses, they become no-growth incinerators of capital and if they keep going, they may find that they cannot make payroll one day—remember WeWork?
You also have the issue of the VCs themselves; do they really want to fund this thing anymore?
A year ago, they knew they could put money in at a $1 billion value because Softbank would do the $10 billion round and then they could dump it on retail.
Even if it was a down-round from Softbank, who cared, they set the mark and everyone else felt like they got a bargain in the IPO.
However, times have changed; who would still value a fake business at $1 billion if there was no hope of an IPO in the near future?
These sorts of little dramas are getting sorted out behind closed doors and not a day goes by without us hearing of another round of VC unicorn layoffs.
As the VC ecosystem has a slow-motion coronary, it’s worth asking what else looks like VC; where else can you mark-up your friend’s portfolio if he’s willing to mark-up yours.
Well, PE sure looks similar—fake marks, unrealistic expectations and a lot of incentive to ignore reality in the hope of bluffing your way into an IPO.
Since then, we’ve seen failures by many smaller companies like Casper (CSPR – USA), which serve to remind equity investors why they shouldn’t buy VC IPOs.
However, PE was notably absent in this drama until recently.
Is the bankruptcy of EnCap’s Southland Royalty, PE’s very own WeWork moment?
Sometimes it’s really hard to tell what something’s worth.
However, this isn’t Schrodinger’s cat; it’s either a healthy business or hurtling towards bankruptcy.
It can’t be both and it should have been aggressively impaired heading into bankruptcy.
Last week I had lunch with a friend who’s rather high up in the PE world.
He repeatedly made the point that many of the marks are simply wrong and a surprisingly large number of mid-decade vintage deals are going sour at an alarming rate.
I suspect there will be many more surprises coming—the sort of multi-billion-dollar write-offs that will forever change PE’s image of low-volatility capital allocators.
The odd thing is that allocators invested in PE due to its Madoff-like volatility profile.
Ironically, they also forgot that this led to a collapse at the end.
If last cycle’s crisis was caused by Madoff’s admission that it was all fake, will this cycle be bookended by PE’s similar admission?
*Featured post photo by Charles Etoroma on Unsplash