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Private equity operational improvements
Dan Rasmussen of Verdad published a posting regarding the operational performance of companies bought by private equity funds to see whether this narrative of the managers shows up in the numbers:
Private equity firms earn high returns by improving the operations of the companies they buy. By taking majority stakes and installing an engaged board, private equity firms can add significant value to often undermanaged small companies. Or so goes the industry marketing spiel.
Verdad’s conclusion? “We don’t see any evidence” of it. Of all of the charts that track the before and after conditions, the only one that really stands out displays the big change in leverage. Thus, “there is a new paradigm to understand the PE model, and it’s very, very simple. By and large, as an industry, PE firms take control of businesses to increase debt.”
A subsequent Q&A addressed questions submitted by readers about the original review. It includes a variety of additional charts.
Life cycles
The latest report from Michael Mauboussin and Dan Callahan is “Birth, Death, and Wealth Creation: Why Investors Need to Understand Corporate Demographics.” It begins, “Valuing the equity of a public company is a bold exercise,” since standard valuation techniques derive much of a company’s value from distant years:
A thoughtful valuation requires confronting some empirical realties: most companies do not live that long and do not generate good returns for shareholders while they are alive.
The report examines “how companies are born and how long they live, why they die, and patterns of shareholder returns.”
Faded giants
Speaking of life cycles, while we know it can happen, it’s always a bit surprising when large, admired investment funds wither away.
In 2016, the Global Absolute Return Strategies product from Standard Life product was a juggernaut. It was the largest open-ended fund in the UK, and counting versions of the strategy in other channels, it had £45 billion in assets. Now, with AUM at just 3% of that, it’s being merged out of existence by Abrdn (which combined with Standard Life in 2017). A story from Citywire Selector provides the play-by-play, as seen by retired allocator Bob Boyda.
Another big name, Sculptor (née Och-Ziff) Capital Managements is being sold to Rithm Capital. According to an article in the Financial Times, the firm still was managing more than $30 billion in assets, but the price of its publicly-traded shares was off more than 90% since its listing in 2007.
A great piece by Marc Rubinstein covers the tumultuous times of the firm. He writes that “as a public company, Sculptor opened the veil on the inner workings of a hedge fund”:
The sixty 10-Qs and 10-Ks it filed with the Securities and Exchange Commission along the way tell a story of how money is made and lost in the industry, how the spoils are shared and how challenges are managed. If you want to understand the business of hedge fund management, Sculptor is a good case to study.
The reasons for the declines of these giants are familiar: scale issues, fights over money, and changes in people, strategies, and the markets (of GARS: “their alpha stream ran dry”).
Questions
A posting from Gustavo Razzetti of Fearless Culture, “The 50 Most Powerful Questions Smart Leaders Can Ask,” is not just for “leaders.” The questions are good prompts for anyone at any level of an organization — and serve as excellent probes when doing due diligence.
Other reads
“Generative AI: Hype, or Truly Transformative?” Goldman Sachs. A nice mix of information and interviews, including one with Gary Marcus, who thinks that “the intelligence of AI systems is being overhyped”:
At the core of all current generative AI tools is basically an autocomplete function that has been trained on a substantial portion of the internet.
“Does Lowball Guidance Work?” Jing Chen, et. al, The CLS Blue Sky Blog. On the competing theories of “earnings uncertainty” and “market appeasement” in earnings guidance; the research suggests that “there are short-term capital market benefits to issuing lowball guidance, but the benefits dissipate eventually.”
“Which Regulatory Filings Are Most Truthful?” Jason Voss, Deception and Truth Analysis.
If you are an investor relying on 10(k)s and (q)s in your due-diligence work then you should know that companies score as more deceptive in the second quarter, and especially in the third quarter.
“The junior bankers who are embarrassed and offended by $300,000 offers,” Daniel Davies, eFinancialCareers. “Of all the strange practices of the investment banking industry, ‘on-cycle recruiting’ for private equity firms is possibly the silliest.”
“Mining for Alpha with Index Funds,” Daniel Sotiroff and Jonathan Baikov, Morningstar. These days, many funds “are passive in the sense that they track an index, but they are active in the risks they take and rewards they seek.” (More on the continuing problem of confusing terminology.)
“A Cautionary Tale For Pension Funds Piling Into Private Markets, Leo Kolivakis, Pension Pulse.
When you own an [infrastructure] asset like this, you need to think and act like the Germans, not like Macquarie.
“There’s a Gaping Hole in the Subscription Lending Market,” Alicia McElhaney, Institutional Investor. Subscription lines have been used increasingly over the last few years (boosting IRRs), but supply is declining.
“When Hindsight Becomes Foresight: Replicating Investment Performance,” Nicolas Rabener, Enterprising Investor. Can you replicate long-short hedge funds using just the S&P 500 and cash?
“The Problem With Performance Attribution,” Clare Flynn Levy, Essentia Analytics.
If you’re an allocator of capital to equity managers, it’s worth asking any manager on your shortlist to show you their decision attribution analysis before you invest.
“How the Fed Saved Structured Note Issuance,” Michael Ashton, E-piphany. “Not everyone hates higher rates!”
“Legal and travel expense drafting in LPAs,” Colmore.
For the majority of the LPAs we reviewed, funds were silent on private air travel, leaving LPs potentially exposed to excessive expense obligations of this nature.
“The State of Organizations 2023,” McKinsey & Company. “Ten shifts that are transforming organizations — and what to do about them.”
(Shameless plug >>) “‘You have to get past the narrative’: How to shine a light on fund shops’ culture,” Tom Brakke and Alex Steger, Citywire Pro Buyer.
Just right
“A great way to think about a model is to use the Goldilocks analogy. A model should not be too complex or too simple. Too complex with too many variables and we have an overfit problem. Too few variables and we are left with a problem that an unspecified factor will drive predictions.” — Mark Rzepczynski.
Playing the hype
Sparkline Capital’s latest research picks up on the AI-hype theme: “Drawing lessons from the dot-com bubble, we show how ‘intangible value’ can help investors navigate the hype cycle.” A couple of pictures show how Sparkline divided (in retrospect) the internet stocks into expensive and cheap cohorts.
The cumulative excess return for each varied during the season of hype and, especially, after the bust.
Disaggregating the total return of the cheap stocks versus the expensive ones, the story is pretty obvious. The expensive ones did show stronger sales growth, but they had been so over-hyped that their valuations (in terms of multiples of sales) had nowhere to go but down — and it was a long way down.
In a similar fashion, Sparkline divides the AI plays into two buckets, arguing that playing the expensive ones will not work this time either.
As with all of Sparkline’s research, this piece is full of interesting charts and ideas. It also includes a look at a hot topic of the day, the exposure of various jobs to AI. The exhibit, “Financial Advisor AI Exposure,” will be of interest to those in the advisory world.
Postings
Once or twice a year, a paywalled posting is made available for all on LinkedIn. The most recent one to be so featured is “Orbiting the Asset Management Hairball,” which explores the tangled web of convention and the possibilities of creativity. (While you’re on the site, reach out to connect.)
“The Dawning Era of Qualitative Analysis” recounts the need for qualitative assessments of asset managers (the core of the due diligence training and services provided by The Investment Ecosystem) — and the emerging tools that can aid that process.
All of the content published by The Investment Ecosystem is available in the archives.
Thanks for reading. Many happy total returns.
Published: July 31, 2023
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