Thursday, October 19, 2017

Private Equity's Asset-Stripping Boom?

Wolf Richter of Wolf Street blog posted a comment, Asset-Stripping by Private Equity Firms Is Booming:
Here are the numbers. Peak chase-for-yield by institutional investors?

Most of the brick-and-mortar retailers that have filed for bankruptcy protection to be restructured or liquidated over the past two years have been owned by private equity firms – including the most recent major casualty, Toys ‘R’ Us. Part of how PE firms make money is by stripping capital out of their portfolio companies via special dividends funded by “leveraged loans” – more on those in a moment – leaving these companies in a very precarious condition.

So just how much have PE firms paid themselves in special dividends extracted from their portfolio companies? $4.76 billion in the third quarter, bringing the year-to-date total to $15.3 billion. So the year-total for 2017 is going to be a doozie.

In all of 2016, this sort of activity – “recapitalization,” as it’s called euphemistically – amounted to $15.7 billion, up from $10.5 billion in 2015, according to LCD, of S&P Global Market Intelligence. LCD’s chart shows the quarterly totals (click on image):


“This high-profile recap activity is a sign of the times in today’s still-overheated leveraged loan market,” LCD says:
Deals such as these typically proliferate when there is excess investor demand, allowing borrowers to undertake “opportunistic” issuance, such as corporate entities refinancing debt at a cheaper rate or, here, PE firms adding debt onto portfolio companies, then paying themselves an often hefty dividend with the proceeds.
As private-equity-owned retailers that are now defaulting on their debts have shown: this type of activity where cash is stripped out of the portfolio company and replaced with borrowed money is very risky.

Leveraged loans are provided by a group of lenders to junk-rated over-indebted companies. They’re structured, arranged, and administered by one or several banks. But leveraged loans are too risky for banks to keep on their balance sheet. Instead, banks sell the structured products to loan mutual funds or ETFs so that they can be moved into retirement portfolios, or they repackage them into Collateralized Loan Obligations (CLO) to sell them to institutional investors, such as mutual-fund companies.

A record $947 billion in leveraged loans are outstanding. They trade like securities. But the SEC, which regulates securities, considers them loans and doesn’t regulate them. No one regulates them.

So why can PE firms strip record cash out of their portfolio companies while loading them up with this risky debt? Because credit markets have gone nuts.

After years of yield repression by the Fed and other central banks, there is huge demand for products that yield just a little more, regardless of the risks. “Excess demand scenario” is what LCD calls this phenomenon. “Hence the relative surge in dividend deals, which are popular with private equity firms, for obvious reasons.”

Despite the risks, as LCD gingerly points out, “institutional investors are keen to maintain strong relationships with private equity shops, which borrow frequently, so in bull credit markets these deals continue to find a home.”

And these already risky leveraged loans have been getting even riskier for investors: In the first half of October, 82% of all leveraged loans issued were “covenant lite,” almost matching the full-month record of 84%, in August, according to LCD. As of September 30, 72.9% of all US leveraged loans outstanding had a covenant-lite structure, the highest proportion ever. So $690 billion in leveraged loans were covenant lite.

This chart shows the surge in the proportion of covenant-lite loans to total leveraged loans over the past three years (click on image):


So what’s the big deal? When there is no default, there is no problem. But when defaults do occur – as they have a tendency to do – or before they even occur, investors in covenant-lite loans have less recourse and fewer protections, and losses can be much higher. As long as investors clamor for risky debt in their energetic chase for a little extra yield, these covenant-lite loans are going to fly.

The leveraged loan market has been sizzling. The S&P/LSTA US Leveraged Loan 100 Index has now set an all-time high on every single day from September 25 through October 15. And that’s how it has been pretty much since the recent low on February 11, 2016 (click on image):

In this kind of Fed-engineered credit market, where risks no longer matter, and where institutional investors are chasing yield and plow with utter abandon other people’s money into risky assets, it’s logical that PE firms are stripping as much cash as they can from their portfolio companies before these companies – like so many retailers now – are toppling.

Why is anyone still buying retailers from private equity firms? Read…  IPO in March, Crushed Today: PE Firm Pushes another Retailer into Brick-and-Mortar Meltdown
Let me first thank Dimitri Chalvasiotis for bringing this comment to my attention. I added Wolf Street blog to my extensive blog roll and will keep an eye out for interesting comments like this one.

A couple of days ago, I wrote a comment where I critically examined those who defended private equity at all cost, going over many issues that rarely see the light of day, including private equity's  misalignent of interests and how buyout firms regularly exaggerate their performance.

The comment above discusses an important source of private equity's returns, namely, dividend recapitalizations (recaps) and links this activity to the hot and bustling leveraged loan market.

You'll recall five years ago, in October 2012, I discussed why private equity is eyeing dividend recaps as credit markets were boming in Europe and elsewhere.

The idea is simple, booming credit markets allow PE firms to borrow cheaply which in turn allows them to saddle their portfolio companies with debt as they "extract" a special dividend.

It's a great way for PE firms to juice their returns but I believe it's all coming to an end very soon. Have a look at the effective yield on a European HY bond index (from BOFA- Merrill Lynch). That's is not a typo – European junk bonds are yielding 2.2% (click on image):


Stated another way, European junk bond spreads hit their tightest levels since July 2007: 258 bps (click on image):


And it's not just Europe. As Charlie Bilello of Pension Partners notes in his wonderful Twitter account, credit spreads are tightening all over, including the US and emerging markets. 

In fact, Charlie notes US Investment Grade credit spreads at tightest levels since July 2007: 102 bps. And Emerging Market High Yield (HYEM) credit spreads at tightest levels since August 2007: 404 bps (click on images): 



Equally interesting, Charlie shows you how the yield on the leveraged loan ETF (BKLN) is down to an all-time low of 3.54% as the S&P Leveraged Loan Index hits an all-time high for the 21st consecutive day (click on images):



Everything is interelated but it's all coming to and end which is bad news for PE firms relying on dividend recaps to make their returns, but also for big banks like Goldman Sachs (GS) which has been quietly crushing it through its debt underwriting activities.

This is why I am short shares of Goldman Sachs (GS) and other financials (XLF), I see more pain ahead as this debt-fueled frenzy comes to an abrupt end (click on image):


What about shares of Blackstone (BX) and other PE titans? They have great yields and nice bullish weekly charts but here too, I'm cautious and would be taking my profits (click on image):


The most important chart to pay attention to right now is the iShares iBoxx $ High Yield Corp Bond ETF (HYG) which has been on tear as US high yield spreads hit a record low (click on image):


I want you to look at that monster run-up and ask yourself how sustainable is this going forward. In fact, things have gotten so out of whack in credit markets that Lisa Abramowicz of Bloomberg reports junk-bond traders are increasingly just buying stocks (follow Lisa on Twitter here, she posts great stuff).

All this just reinforces my belief that the bubble economy is set to burst and when it does, deflation will hit the US and we will experience the worst bear market ever, crushing many chronically underfunded pensions and pretty much all institutional and retail investors.

The private equity kingpins know all this as do the hedge fund elites. They're not stupid which is why asset-stripping is booming now.

Having said this, I want to be very careful here. I shared the Wolf Street comment above with professor Claudia Zeisberger at INSEAD who is an expert in private equity and she kindly shared this with me:
Correctly describing the situation and demand driving pricing and terms cov lite or cov free. However a lot of data is presented in absolute terms and not relative terms, i.e. relative to a) LBO investment activity (more means more original loans) and b) LBO portfolio holdings (with holding periods lengthening there is more room / demand for Lev Recaps).

More important: Picking Retail (a sector I am quite familiar with) is also a cheap shot as the secular changes from e-commerce/ Amazon are re-rating the whole brick & mortar business, who are broadly screwed with or with or without PE ownership.
I thank professor Zeisberger for sharing her wise insights with me.

I leave you with some questions to ponder for pensions. How will the end of private equity's asset-stripping boom impact the performance of PE funds going forward? How will it impact the overheated leveraged loan market? What about private debt markets and CLOs? What will be the impact in these markets?

These are all important questions to ponder for large pensions investing in private equity, CLOs (like HOOPP's new risk retention vehicle) and private debt markets (like CPPIB and PSP).

Again, if you have anything to add, you can reach me at LKolivakis@gmail.com.

One final note, after reading last comment in defense of private equity, Tom Sgouros of Brown University noted the following on this passage from Joe Lonsdale's article:
The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, it is the PE firm which ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them.
The red part is pretty obviously false if you look at the history of any of the high-profile acquisitions and the guys who engineered them out there. And let's not forget that "redeploying company assets" was often shorthand for "stealing the pension fund."

The PE industry is pretty much why there are so few US pension systems left in private industry. The PE guys make out and leave dust in their wake -- sometimes. Perhaps there are ethical PE companies, but there are lots of them that just steal, and until there is a way to tell the difference, the industry will suffer from a bad name.
You will recall Tom wrote an interesting research paper examining whether fully-funded US pensions are worth it. I sent him the Wolf Street comment above and he replied:
It sounds much better when you call it "redeploying assets" or "enhancing productivity", doesn't it?

I like this line, from a linked article at the same site: "Why are investors still buying brick-and-mortar retailers – or anything – from PE firms? No one knows. But inexplicably, it’s still happening."
Indeed, no one knows, but there is still value in these investments and the best PE funds will be able to unlock it, with or without asset-stripping.

Below, private equity now employs a huge number of employees across the globe, presenting great funding opportunities for firms, says Claudia Zeisberger professor at INSEAD.

Professor Zeisberger is the author of two recently released companion books, Mastering Private Equity: Transformation via Venture Capital, Minority Investments and Buyouts and Private Equity in Action: Case Studies from Developed and Emerging Markets. She knows her stuff and she's right, as valuations in PE soar, operational efficiency is paramount but as shown above, trends in leverage are flashing a warning sign.

Unfortunately, as this bubble economy is set to burst, I would be very careful with all risk assets across public and private markets. I foresee a lot of develeraging pain ahead so be careful.

Wednesday, October 18, 2017

Has Kentucky Lost its Pension Mind?

Tom Loftus of the courier-journal reports, Kentucky pension crisis: Bevin plan would move workers to 401(k)-like plans:
After months of planning and closed-door negotiations, Gov. Matt Bevin and GOP legislative leaders on Wednesday released a plan they say begins to tackle Kentucky’s multibillion-dollar pension debt while honoring promises to retirees and public employees.

As expected the plan calls for transitioning most public employees from traditional pension plans to 401(k)-like plans – but it does so in a much more gradual way than recommended by the Bevin administration’s pension consultant.

New workers and teachers will go into 401(k)-like plans, but instead of immediately shifting current state and local government workers to 401(k)s, those workers would be able to remain in their current pension plans for 27 years.

Current teachers with 27 years of service also would be moved to the 401(k)-style savings plans. But their plans will be more generous than those of other public employees to compensate for the fact that teachers do not draw Social Security benefits.

To avoid a rush of teacher retirements, those teachers will be given an option of remaining in their current traditional pension plans for three additional years.

And both current and future workers in “hazardous duty” jobs like law enforcement would not go into the 401(k)-type plans. They would retain their current pension benefits instead.

The plan also would bring legislators, who have more generous benefits, into the retirement system of other state employees. And it would end the ability of teachers to use accumulated sick days to boost their pension benefits – but not until July 1, 2023.

And the plan would begin to pay for pensions under a new approach “that mandates hundreds of millions more into every retirement plan, making them healthier and solvent sooner,” a summary of the plan said.

“If you are a retiree, if you are working to be a retiree at some point, you should be rejoicing,” Bevin said. “... It guarantees by law that your pension is going to be funded. There will be no more kicking of the can down the road.”

Some immediate response to the plan questioned Bevin's statement that all promises have been kept.

"I think the plan includes some very harsh cuts to benefits," said Jason Bailey, executive director of the Kentucky Center for Economic Policy. Bailey said the handouts summarizing the plan say cost-of-living increases for teacher retirement benefits would be suspended for five years and that teachers and other public employees will have to pay more for health care benefits.

The governor released the framework for the reforms at a news conference in the Capitol with the top leaders of the General Assembly’s Republican majorities – House Speaker Jeff Hoover, of Jamestown, and Senate President Robert Stivers, of Manchester.

Bevin has said all year that he would call a special legislative session in 2017 for lawmakers to pass a reform plan to set the state on course to pay off pension debts. Those debts are officially listed at more than $40 billion, but Bevin estimates them at more than $64 billion.

The plan released Wednesday is only an outline of the bill to be considered. And Bevin did not say when that session will begin.

“As soon as we are ready,” he said when asked when he will call the session. “There’s still a little ‘I’ dotting and ‘T’ crossing” before that announcement, Bevin said.

The plan is much friendlier to employees and retirees than many of the highly controversial recommendations offered in August in a report by the administration’s Philadelphia-based consultant – PFM Group. It does not, for instance, call for raising the retirement age for public employees or the clawing back of any benefits earned by current retirees.

“Nothing is changing for retirees," Bevin said. "They’re going to be getting everything they’re getting now.”

And Bevin also said he believes that the terms of the 401(k) plans that will be offered to employees and teachers are generous. “It will be a very good plan.”

Jim Carroll, president of the advocacy group Kentucky Government Retirees, said he appreciated the effort to respect the contractual rights of current state workers but said he believes it would be illegal to “arbitrarily” reduce an employee’s pension benefits after 27 years.

Carroll also said that the toughest decisions now must be made during the 2018 regular legislative session, when lawmakers must find the money for the new approach to funding pensions.

“We’re going to need to hear from leadership how they’re going to come up with the money,” Carroll said.
In late August, I warned my readers, Kentucky's pensions are finished, and now I see they're proposing the dumbest policy to "fix" their pension crisis, namely, shifting new teachers and those with 27 years of service into a 401(k) plan.

In that comment, I stated:
[...] scraping a defined-benefit plan to replace it with a defined-contribution plan is a really horrible idea. It shifts retirement risk entirely onto workers and leaves them all exposed to pension poverty down the road. That's the brutal truth on DC pensions, they're far, far inferior to large, well-governed DB plans.

The public-sector unions and retirees should fight tooth and nail to maintain DB plans but they will need to share some of the risks attached to these plans in order to see them regain fully-funded status.

The biggest problem is lack of governance. You can almagate all these plans at the state level, increase the retirement age for some and even introduce some form of shared-risk but if you don't get the governance right, Kentucky's defined-benefit plans won't survive and this will impact the state in a very negative way (both in terms of attracting qualified people to the public sector and in terms of economic activity).

Hurricane Harvey devastated Houston and other cities in Texas but they will rebuild that great state. Kentucky's pension hurricane has been going on for years and very few were paying attention, let alone sounding the alarm.

And now, I'm afraid to say, Kentucky's pensions are finished, irrevocably changed and the future of public defined-benefit plans in that state is grim at best. Welcome to America's new pension normal.
Let me ask you a question, would you rather have Kentucky teachers' pension plan or Ontario Teachers' Pension Plan which is professionally managed and fully funded? There's a reason why we pay Canada's pension overlords millions in compensation, to avoid pension blowups like the one in Kentucky and other states like Illinois.

Shifting new teachers to a 401(k) plan is a politically expedient and asinine proposal that will cost Kentucky's education system and economy dearly in the long run.

In fact, earlier this week, John Cheeves of the Herarld Leader reported, Report says Kentucky’s proposed pension ‘reforms’ could make everything worse:
Sweeping changes recommended for Kentucky’s public pension systems would cost taxpayers and public employees more money while making public employment far less attractive to future generations, according to a report released Monday.

PTA was hired to examine the PFM Group’s recommendations by two groups critical of those proposals, the Kentucky Public Pension Coalition and the Kentucky Retired Teachers Association.

Although the Bevin administration paid the PFM Group nearly $1.2 million for its advice, Republican lawmakers meeting privately with Bevin to draw up a bill for a special legislative session on pensions have said that not everything the PFM Group suggested will be included.

A spokesperson for Bevin did not respond Monday to a request for comment about the report by Pension Trustee Advisors.

The crux of the PFM Group’s proposals — that it would be cheaper to provide public employees with largely self-financed defined-contribution accounts — isn’t accurate, Fornia wrote.

For one thing, he said, either the state of Kentucky will have to spend millions of dollars every year to cover the new costs of Social Security for school teachers or else it will have to force that burden onto local school districts. At present, teachers get pensions, and they are excluded by law from Social Security withholding.

Changing to 401(k) accounts would also cost the state more than maintaining the model it has used since January 2014, which is known as a hybrid cash-balance plan, Fornia wrote. Under the PFM Group’s proposals, Kentucky simultaneously would have to pay down tens of billions of dollars in unfunded pension liability from past years as well as the higher administrative costs and investment fees associated with defined-contribution plans, Fornia wrote.

“The proposed plan for future employees quite simply is more expensive,” Fornia wrote. “There is no savings to Kentucky or its public workers from the proposed changes.”

From the viewpoint of public employees, the loss of pensions means an end to financially secure retirements, Fornia wrote. Even if state workers and school teachers contribute the maximum sums allowed to their 401(k) account every pay period and enjoy an unbroken string of good fortune in their stock market investments, which seems doubtful, they are likely to run out of money if they survive into their 80s, he wrote.

The change also would end the disability pensions that thousands of injured or sickened public employees in Kentucky have used to retire early when medically necessary, Fornia said. Under the model proposed by the PFM Group, future workers would be left with no such safety net.

Finally, Fornia challenged the idea that defined-benefits pensions don’t work. They work fine when you pay the bills on time, he wrote. Fiscally prudent states that properly funded their retirement systems, such as South Dakota, Oregon, Wisconsin, North Carolina, Tennessee and New York, aren’t struggling today. But Kentucky governors and legislators failed for most of the last two decades to adequately fund the state’s two major pension systems, leading to the massive shortfalls the state faces now, Fornia wrote.

“It is disingenuous to simply conclude that defined-benefit programs are inherently not sustainable,” he wrote.
Defined-benefit pensions are the only true pensions and they work just fine provided:
  • States top them up regularly and contribution holidays are made illegal
  • They get their investment assumptions right to discount future liabilities properly
  • They get the governance right to manage more assets internally and lower costs
  • They adopt a shared-risk model which forces the plan's sponsors to share the risk equally, meaning if they run into trouble and there's a deficit, they need to raise contributions or cut benefits (typically lower cost-of-living adjustments) or both to make up for the shortfall and get back to fully-funded status
Public-sector unions need to accept some risk-sharing of their plan and get the governance right or else these DB plans are doomed to crumble.

Anyway, it looks like Kentucky has lost its pension mind and this is just the beginning. I foresee the same thing going on in other states as US pension storms from nowhere gather steam.

I know, the Dow Jones smashed through 23,000 on Wednesday led by IBM and this is great news for 401(k)s but be careful, when the mother of all bear markets hits us, you will all be singing a very different tune.

Below, a quick look at the figures behind Kentucky's pension shortfall. And Kentucky Governor Matt Bevin says he doesn't support legalizing recreational marijuana in Kentucky as a way to raise revenue to aid the state's ailing pension system. 

Maybe not but he and his consultants are smoking some good pot if they think shifting teachers to 401(k)s is the solution.

Read more here: http://www.kentucky.com/news/politics-government/article179329906.html#storylink=cpy


Tuesday, October 17, 2017

In Defense of Private Equity?

Joe Lonsdale, a founding partner at 8VC, wrote a comment on CNBC, In defense of private equity:
The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does.

The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.

Technological innovations and centralization of farming operations – from the green revolution to the present – enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant.

This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services.

The only way to create prosperity is to do more with less. In economic terms, an increase in productivity is an increase in the amount or quality of output generated for each unit of input. Jobs do not make society wealthier – productivity does.

The original example of an industry that has learned to do more with less is agriculture. On a medieval farm, an entire family would have to work to eke out a subsistence living for themselves. But today, a small number of farmers produce enough food to feed the entire planet.

Technological innovations and centralization of farming operations – from the green revolution to the present – enabled the agricultural sector to do much more with far less. Between 1930 and 2000, U.S. agricultural output quadrupled, even though material inputs such as land, labor, and capital remained constant.

This enormous productivity boost freed up Americans to specialize in other sectors: building, manufacturing, and creating new goods and services (click on image).


As the example of agriculture illustrates, there are multiple ways to increase economic productivity. One is to build and finance companies with entirely new innovations, typically the domain of the entrepreneur and the venture capitalist.

Another is to improve the way existing companies work, often by merging many smaller companies to form one large one, or restructuring management goals and employee incentives within a company.

This is typically the domain of the "private equity" firm or a large acquisitive corporation. The two methods sometimes complement each other: when a VC-backed entrepreneur develops a new technology, corporations or PE-like firms often scale the product and quickly spread it throughout the economy.

How private equity works

Today, a private equity or "PE" firm is a company that raises funds from institutions and wealthy individuals and then invests that money in buying and selling businesses. PE firms are usually "activist" investors, which means that rather pursuing a passive buy-and-hold strategy, they are involved in managing (fixing…or screwing up) the internal operations of the businesses they acquire.

Imagine you're an investor who wants to make the economy run more productively by improving as many businesses as you're able to, starting with those with the most potential for improvement. You pore over a map of the economy which shows how different sectors have evolved, which business models have proven effective, where consumer demand is trending, and rafts of other economic data. You want to do more with less – but how?

The leaders of private equity firms find themselves in exactly this position, and employ some of the following strategies:
  • Combining back offices of multiple firms to cut redundant costs. Sometimes PE firms will bundle several companies within an industry vertical to reduce supply chain costs. They may also combine an ailing company with a healthy company so that the former can develop better processes and become more productive.
  • Aligning incentives by increasing CEOs and operational officers' stake in their business. This technique rewards management for increasing company growth and performing a successful company exit.
  • Rescuing and restructuring businesses that are squandering resources. A common target for a PE firm is an older company which lacks financial discipline, perhaps with inefficient middle management, or where executives spend money on private jets and extravagant parties. This kind of firm benefits immensely from the tutelage of private equity firms experienced at leading and running businesses. By aligning rewards with performance (rather than nepotism or tradition), PE firms can make portfolio companies much more productive.
  • Locating great sectors and geographies to invest in. PE firms may be able to spot undervalued industrial sectors or localities that others have missed. Capitalizing these areas allows them to develop and thrive at their full potential.
  • Using equity capital more efficiently. The capital markets are highly competitive, and securing loans ("leverage") for deals requires finesse. Though the popular press often disparages "financial engineering", reorganizing a company's capital structure can free up money to deploy to other parts of the business or the economy. Of course, irresponsible leverage makes a firm more likely to fail. But the market accounts for this – investors in private equity firms carefully monitor their investments. A PE fund with failed portfolio companies will have trouble raising as much money and freely determining how to allocate it next time around.
A good example is Carlyle's buyout of Hertz Corporation in 2005.

After the buyout, Hertz improved operational efficiency in a variety of ways – for instance locating car cleaning and refueling services in the same parking lots. Not only did these improvements raise Hertz's value by $3B, they forced the entire car rental industry to respond with innovations of their own. During the same period, Avis-Budget and Dollar-Thrifty profit margins and labor productivity increased substantially.

Another example of private equity techniques at work is the brewing industry. The average worker at a North American brewing company is 7x as productive as his counterpart in 1950. (According to "Brewed in North America: Mergers, Efficiency, and Market Power," an academic paper published April 28, 2016, by Paul Grieco, Joris Pinkse and Margaret Slade.)

Private equity groups such as 3G Capital, which merges and restructures brewing operations, have made the industry much more efficient.

Private equity and its discontents

The classic critique of private equity is that it employs financial engineering tricks, such as increasing leverage and minimizing tax liabilities, rather than making real operational improvements.

Venture capitalist Michael Moritz of Sequoia recently claimed, for instance, that PE is akin to "making a small down payment on your neighbors' house; paying for the balance by taking out a mortgage secured by their savings, jewelry, silverware and car; selling off the contents of their property; and then siphoning off some of the loan for yourself."

Similar invectives were hurled around during the 2012 electoral campaign of Mitt Romney, who helped create Bain Capital. Like any industry, PE is occasionally corrupt – as for instance when it charges inmates high rates on interstate phone calls, in partnership with crony state governments.

But the image of private equity as a parasitic form of business completely misses the point.

The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, it is the PE firm which ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them.

Furthermore, enabling companies to do more with less allows workers to specialize in other areas, and frees up wealth with which investors and management can capitalize internal improvements or ventures in other regions of the economy. PE firms succeed to the extent that their portfolio companies succeed, and to the extent that their portfolio companies succeed, America prospers.

Another conventional critique levelled by Moritz is that PE destroys millions of jobs when cutting costs at portfolio companies. This is empirically false – the private equity industry as a whole is responsible for large job creation as well as destruction, with only modest net job losses.

But the deeper fallacy with this argument is that full, constant employment is falsely seen as the ultimate good in America's economy.

If we wanted to create full employment it would be easy: we could simply ban 20th century agricultural technology, immiserating millions of Americans and forcing them back into farm labor. It's easy to intuit that this would be a bad idea, but it's harder to imagine the economic progress that layoffs and labor migration imply.

In truth, creative destruction of antiquated jobs and invention of new forms of labor drives productivity growth, and PE firms are integral to this process.

Finally, some argue that PE only enriches a select few at the expense of ordinary Americans. In fact, the largest investors in PE are American pension funds, which have committed hundreds of billions of dollars to the American private equity industry.

PE assets make up 9% of CALPERS' portfolio, for instance, and have generated an annualized net return of 12.3% over the last ten years. When private equity firms succeed, every state government pension plan, university endowment, and large philanthropic endowment shares in their profits. It's no stretch to say that the primary beneficiary of the private equity industry is the American public.
Private equity and venture capital

Private equity and venture capital have much in common, and The Economist is partly correct to characterize VC as "private equity for fledglings".

Like their counterparts in PE, VC funds have long lifespans, which allows partners to cultivate long-term growth in portfolio companies rather than focusing on quarterly showings. And like private equity firms, the modern VC is actively involved in coaching and advising its portfolio companies (though ironically, PE is often more hands-on and entrepreneurial than VC because the latter has the more limited discretion of a minority shareholder).

Jim Coulter of TPG noted that whereas VC is in the business of mutation, PE is in the business of evolution. Where VCs fund "mutant" start-ups that offer completely novel technological innovations, private equity firms facilitate the process of natural selection to ensure that only the "fittest" companies survive. This is an important distinction between the two industries, and there are other technical differences. But broadly speaking, you can't believe in the fundamental value proposition of the venture capital industry unless you believe in the basic paradigm of investment, assistance, and economic repair pioneered by PE.

We believe that in the coming decade, segments of the private equity and venture capital industries will converge and adopt similar strategies. Returns will disproportionately accrue to firms that combine the best of each. In the 1980s – the heyday of the private equity industry – firms such as KKR, Blackstone, Carlyle and Apollo tapped the under-deployed resources of banks to purchase, restructure, and resell corporations.

But leveraged buyout (LBO) techniques are now "commoditized," and the industry is extremely saturated: PE backs 23% of America's midsized companies, and 11% of its large companies. The private equity industry remains valuable, but in order to generate unusual returns it must "evolve" itself.

PE firms have always tried to harness new innovations, but a surge of new information technologies has made it increasingly valuable for some private equity firms to partner with leading entrepreneurs and technologists – many of whom are located in Silicon Valley. Commercial data is exploding in volume and variety, and metrics are becoming much more precise. Private investors of the future will use technology platforms to evaluate formerly uninteresting assets as hidden stores of data, which will make their businesses and industries more efficient. New information will allow top investors to better assess consumer demand, supply chain logistics, and industry-level shifts, as well as determine where to open channels of communication and dedicate resources. Data-driven PE firms will save resources, increase their margins, and become more valuable to their partners.

Venture capitalists able to draw on the top networks of talented leaders and builders in Silicon Valley were among the first to develop an armamentarium of data-driven procedural improvements for their portfolio companies. Hybrid groups such as Vista were among the first to pioneer these techniques in the buyout space. Private equity firms working closely with venture capitalists and technologists may be able to unlock assets that others have not leveraged and build technology cultures to iterate on solutions that make these assets more productive. Some may even reclaim 1980s or 1990s-level returns.

At the same time, the best VCs will begin to imitate and adopt PE strategies. Scaling major technological breakthroughs in certain industries requires armies of people and significant resources – private equity's bread and butter. VCs may also begin to increase their return on equity capital of late-stage portfolio companies with debt financing, drawing on the private credit divisions of investment banks, PE firms and more.

There is still a large cultural rift between the two worlds; the culture of Silicon Valley is very different from the "Wall Street" mentality of the American financial establishment.

Fortunately, open-minded individuals in each field are establishing rapport and exchanging insights. We have been lucky to add luminaries including Henry Kravis and Geoff Rehnert as investors and advisors to 8VC, and Sir Deryck Maughan as a board partner. Communication and cooperation between our industries will only continue to improve as the distinction between elite private equity and venture capital investors becomes less meaningful.

Conclusion

Critiques of PE reflect a naïve understanding of what creates economic prosperity. Private equity investors are an integral part of the economy, and should be celebrated for making our country wealthier. The confluence of the venture capital and private equity industries will only make each more productive, strengthening and fine-tuning the economy. Savvy, competitive investors able to build, buy and fix companies will continue to stimulate growth by allowing us to do more with less – the only way to create prosperity.
Are you all ready to take out your American flag, stand up and salute the private equity industry?

I like Joe Lonsdale, think he's a very sharp guy, but he's only showing you the rose-colored portrayal of the private equity industry and obviously has a vested interest talking up this supposed "convergence" between venture capital and private equity.

I'm more skeptical. First, I'm highly skeptical on venture capital ("VC") funds and wouldn't invest in most of them, even the so-called cream of the crop.

That goes back to my old days at PSP in 2004 when I was helping set up private equity there and called Doug Leone of Sequoia three times to secure a brief meeting with Gordon Fyfe and Derek Murphy. "Listen kid, I like your persistence and will meet your top guys for 15 minutes but we're fighting over whether Harvard or Yale will receive an allocation. We don't want or need pension money. Our last $500 million fund was oversubscribed by $4.5 billion. I'll save your pension a lot of time and money, don't invest in VC, you will lose your shirt."

I remember Gordon and Derek loved that meeting, they both came to see me when they got back and told me it was "awesome". Derek grumbled something like "I've never felt so poor in my life".

Later, during the financial crisis, when I worked at the Business Development Bank of Canada (BDC) for two years, I saw huge losses in the venture capital portfolio. It was a disaster. The guy who hired me, Jérôme Nycz, eventually took over that department and he was appointed Executive Vice President, BDC Capital in 2013. Last I heard, they are doing well.

But make no mistake, VC is very competitive and it's extremely difficult to make money even for the Sequoias of this world. I'm pretty sure they'd gladly jump on pension money these days instead of thumping their chest, bragging about internal disputes over whether Harvard or Yale gets an allocation.

In terms of the overall private equity industry, VC is peanuts and it will always remain peanuts. I foresee a major, MAJOR, shakeout in the VC world over the next three to five years and it will rock Silicon Valley to its core.

What about private equity? Just like Canada's large pensions, they've been piling on the leverage, as noted in a recent Prequin survey, to the point where leverage on US LBOs is at the highest level since the financial crisis (click on image):


You might be wondering why are they piling on the leverage? Why not? Central banks have effectively aided and abated the private equity/ hedge fund/ banking industry to the point where they'd be stupid not to crank up the leverage to squeeze more private equity dividends from their portfolio companies (as they saddle them with debt) to enrich their payouts (click on image, tweet from 13D Research):


Who else are private equity titans squeezing? They're squeezing pensions on fees, especially chronically underfunded US pensions who are seeing their funded status deteriorate as PE and hedge fund kingpins climb higher on Forbe's list of America's most affluent (but some are falling off the list).

Now, don't get me wrong, private equity is an important asset class for all pensions but as I've reported, these are treacherous times for the industry and there is a serious misalignent of interests.

All you institutional private equity investors need to read this comment of mine and then go read Sebastien Canderle's book, The Debt Trap: How leverage impacts private-equity performance, because many of you are totally clueless on all the shenanigans private equity funds do to pull the wool over their investors eyes.

In fact, I highly doubt Joe Lonsdale has read Sebastien's book and unlike him, Sebastien has worked at top private equity funds and has seen first hand all the ways PE funds manipulate data or make decisions in their, not their investors' best interests.

Lonsdae talks about productivity gains and how private equity has helped "unleash" them but it's all nonsense because the truth is the financial sector is heavily subsidized by the Fed and and other central banks. Go read Charles Hugh Smith's comment on the endgame of financialization being stealth nationalization where he posted this chart (click on image):


All this cheap money primarily benefits the "lords of finance" but nobody talks about Wall Street welfarism which is rampant and has totally corrupted capitalism and our social democracy. They only frown upon welfare checks going to the poor and disabled, you know, the "underclass" of society who are only "leaches" according to them even if they need this pittance of money to survive.

What else does Mr. Lonsdale neglect to mention? How about a recent MIT study that found buyout firms regularly exaggerate their performance:
Private equity managers tend to inflate returns when public markets do well, according to research from Massachusetts Institute of Technology’s Sloan School of Management.

A Sloan paper written last month found that buyout fund and venture capital managers, who have some discretion in calculating investment performance, are influenced by public equity gains posted after a quarter has ended. When public markets are subsequently up, private equity managers rate their own performance higher for the quarter gone by, according to the study.

“We make no claim that this behavior is intentional,” Megan Czasonis of State Street Corp.’s research group, Mark Kritzman, a senior finance lecturer at MIT, and David Turkington, a senior vice president at State Street Associates, said in the paper. “It is quite plausible that private equity managers subconsciously produce positively biased valuations merely because they are optimistic.”

[II Deep Dive: Most Private Equity Managers Think Returns Will Fall]

The researchers studied company-level valuation data from State Street Global Exchange’s private equity index, which represents more than half of all global private equity assets. For the first three quarters of the year, they found that private equity valuations were higher if public markets performed well immediately after the quarter ended. But when subsequent public market performance was negative, private equity valuations were not affected.

By contrast, venture capital managers did tend to downgrade their own valuations following several periods of persistent public equity losses.

“Private equity performance is not recorded immediately after the end of the quarter,” the researchers explained. “Instead, it is released over a period of one to three months.”

The reporting delay means private equity managers may be influenced by public equity market performance after the quarter is finished, according to the study. But in the fourth quarter, when private equity valuations are audited, the performance inflation disappeared.

“Private equity managers are less inclined to produce biased valuations when they are faced with audits,” the researchers said in the paper. “As such, we should expect private equity to produce, on average, higher returns relative to the public market in the first three quarters than in the fourth quarters.”
I know Mark Kritzman, met him at PSP years ago. He is a serious researcher who has done great research in finance.

Their findings are right, you need to regularly audit private equity managers who have quite a bit of discretion in calculating their performance. Also, there is a reason why private equity has aroused the SEC's attention, so don't assume everything is always kosher in the numbers or fees.

In fact, my friends over at Phocion Investments here in Montreal just posted this on their website, Private Equity Valuation Shortcomings Can Be Mitigated With Adoption of GIPS:
Private Equity is an asset class that has garnered increased interest from institutional and accredited investors since the Financial Crisis, with Pension Funds and Family Offices demonstrating especial keenness. The driving force for the fervor is that PE investors are attracted to investment premiums for assuming PE’s poor liquidity and reduced degree of single asset transparency. Investors are also attracted to the perception of PE’s lower level of pricing volatility. In this article we explore some of the valuation shortcomings that investors are exposed to when owning Private Equity funds. ‎

GPs Want to Value Assets as High as Possible


When a Private Equity fund is recently established it can contain a large component of portfolio assets whose valuations are unrealized. When placing a quarter-end value on such unrealized assets, the General Partner (“GPs”) typically uses valuation techniques that adhere to certain industry guidelines that offer a great degree of flexibility. This self-assessment practice opens investors up to the possibility that GPs will utilize high comparable multiples that contribute to increasing the fund’s overall valuation. The GP is motivated to do so because the higher the portfolio’s asset size, the greater will be the size of the GP’s compensation that is derived from management fees.

LPs Have Trouble Identifying Source of Performance

When acquiring an investment in a PE Fund, Limited Partners (“LPs”) must accept the lack of transparency in performance. For instance, return calculations are not provided at the investment level. As such, the LP cannot identify the sources of returns, thus rendering the manager evaluation of skill or luck to a mere a guessing exercise. LPs have no way of objectively assessing as to whether GP performance explanations yield truth or fiction. LPs must make certain to assess whether they are being properly compensated in exchange for PE Fund’s investment performance transparency being stacked in the GP’s favor.

GPs Are Often Structured With Poor Valuation Controls

GPs often perform portfolio asset valuation internally which can yield poor policies, procedures and controls. Valuation policies are often structured to allow for too much flexibility, which can lead to artificially high net asset values (NAVs) and misleading internal rates of return (IRRs). The GPs’ valuation discretion can also produce a lack of consistency in valuation among different investments. Furthermore, the absence of an independent, third-party valuation agent makes it difficult to confirm valuation accuracy. Even then, some independent evaluators lack expertise at pricing hard-to-value assets. To top it all off, it is not common practice to have a valuation committee as part of a GP’s corporate governance program.

Concluding Remarks

The first step towards working in investors’ best interest of is to adopt best practices. The CFA Institute has developed standards referred to as he Global Investment Performance Standards (GIPS) that provide guidance to properly value Private Equity investments. It is very unlikely that GPs will adopt GIPS on their own. Moreover, regulators are likely to lack the necessary courage to make GIPS a requirement any time soon. Henceforth, we propose that institutional and accredited investors band together and demand adherence to GIPS. Walking away from non-GIPS PE funds will eventually get the message across. Eventually, GPs will be looking to check the GIPS box to satisfy investor needs. If GIPS is implemented across PE firms and on a broad basis, this enhanced integrity would benefit all stakeholders. That is something worth striving to achieve and there is no better time than the present to set the wheels in motion.
You can read the PDF version here. When it comes to operational and performance risks of your hedge funds and private equity funds and all your investments, you should absolutely consider the team at Phocion Investments who have experience and aren't going to offer you some bogus "cookie cutter" report which is a cut and paste of other reports (I'm shocked at how careless large institutional investors have become when it comes to thorough due diligence on all their external managers).

I agree with my friends at Phocion. If GIPS is implemented across PE firms and on a broad basis, this enhanced integrity would benefit all stakeholders. That is something worth striving to achieve and there is no better time than the present to set the wheels in motion.

It's funny how we have a double standard when it comes to stringent (GIPS compliant) valuation policies in public markets as opposed to private markets.

No doubt, shenanigans happen everywhere and I don't buy for a minute that it was only HSBC which was frontrunning its clients in FX. That nonsense happens all the time everywhere as FX is a license to steal for big banks but what they don't tell you is sometimes the banks eat the losses and sometimes it's the clients who eat the losses (and all the big chiefs at HSBC who knew about this trade are still there enjoying millions in compensation).

My old mentor at McGill University during my undergrad years, Tom Naylor, the combative economist, used to warn us all the time, "the world is a sewer" and "don't believe anything you read until it's officially denied."

I didn't post this comment to attack Joe Lonsdale or the private equity industry. I actually believe private equity plays a critical part in all pensions' portfolios and it deserves to because over a long investment horizon, private equity has offered compelling returns over public markets (even if they're somewhat exaggerated).

I just want institutional investors to be better informed and to realize there are a lot of issues in private equity they absolutely need to be made aware of. It's not always as straightforward as it seems and there are important operational and investment risks that need to be carefully assessed, including valuation risk, liquidity risk and funding risk.

For example, go read this excellent BVCA report on risk in private equity. I note the following on funding risk:
When reflecting on the last financial crisis, some investors faced severe funding issues. The most prominent case was from the university endowment of Harvard Management Corporation who issued a bond of more than USD 1bn to fund their future capital calls and considered selling a private equity portfolio of around USD 1.5bn, when the average discount on the secondary market was between 40% and 50%. Even CalPERS (the largest US pension fund) sold some of their listed stocks in order to be prepared for potentially paying future capital calls for private equity funds according to an article in the Wall Street Journal.

Listed private equity vehicles which ran an over-commitment strategy experienced similar issues. APEN, a Swiss-listed vehicle had to go through significant restructuring, adding a new financial structure as well as selling on the secondary market so as not to lose any of its private equity assets. It should be noted, however, that many pension funds and insurance companies investing in private equity did not have to take drastic measures during this time period and were able to cope with the change in cash flow profile because they managed their risks from the outset by limiting their allocation to private equity. Additional reasons for the limited allocation to private equity have been the possibility for them to match it with their incoming cash flows, the possibility to liquidate other liquid assets beforehand and having more diversified portfolios.
Once again, I don't claim to have a monopoly of wisdom on pensions and investments so if you have anything to add, feel free to reach out to me at LKolivakis@gmail.com and I'll post your comments for a small token fee.

I'm kidding, no fee required to email me your thoughts but a lot of you who benefit from reading my thought-provoking comments seriously need to step up to the plate and either donate or subscribe using PayPal on the right-hand side under my picture.

Trust me, I don't figure among Canada's pension overlords, I collect a pittance from my blog but dollar for dollar, I'm probably the most powerful person in Canada's pension industry you never heard of (by default, not by choice). It's too bad I cannot leverage all this knowledge to get compensated properly for all the work that goes into these comments.

Anyway, it's all good, Google makes the big bucks and provides me with a platform to share my knowledge and important insights from pension and other experts. You all get to enjoy it for free but for those who can, please show your financial support. It's greatly appreciated.

Below,  Joe Lonsdale, 8VC founding partner, talks about reinventing the way technology is used to monitor big data problems. Lonsdale is superb when he sticks to things he understands.

And private equity now employs a huge number of employees across the globe, presenting great funding opportunities for firms, says Claudia Zeisberger professor at INSEAD.

Professor Zeisberger is the author of two recently released companion books, Mastering Private Equity: Transformation via Venture Capital, Minority Investments and Buyouts and Private Equity in Action: Case Studies from Developed and Emerging Markets. She knows her stuff and she's right, as valuations in PE soar, operational efficiency is paramount but as shown above, leverage has soared back to financial crisis levels which is a warning flag.

Unfortunately, as this bubble economy is set to burst, I would be very careful with all risk assets across public and private markets. I foresee a lot of develeraging pain ahead so be careful.

Update: After reading this comment, Tom Sgouros of Brown University noted the following on this passage from Joe Lonsdale's article above:
The primary way to make money in private equity is to make portfolio companies more efficient and healthier in the long run. If a PE firm saddles a portfolio company with such a heavy debt burden that the company is unable to return a profit, it is the PE firm which ultimately suffers. Private equity firms are fundamentally incentivized to improve and strengthen the operations of the companies they control, not to cripple them.
The red part is pretty obviously false if you look at the history of any of the high-profile acquisitions and the guys who engineered them out there. And let's not forget that "redeploying company assets" was often shorthand for "stealing the pension fund."

The PE industry is pretty much why there are so few US pension systems left in private industry. The PE guys make out and leave dust in their wake -- sometimes. Perhaps there are ethical PE companies, but there are lots of them that just steal, and until there is a way to tell the difference, the industry will suffer from a bad name.
You will recall Tom wrote an interesting research paper examining whether fully-funded US pensions are worth it. I thank him for sharing his wise insights and welcome the views of others.

Monday, October 16, 2017

The Coming Renaissance of Macro Investing?

John Curran, a partner and head of commodities at Caxton Associates, and chief investment officer at Tigris Financial Group, a family office, wrote a comment for Barron's, The Coming Renaissance of Macro Investing:
In the summer of 1974, Treasury Secretary William Simon traveled to Saudi Arabia and secretly struck a momentous deal with the kingdom. The U.S. agreed to purchase oil from Saudi Arabia, provide weapons, and in essence guarantee the preservation of Saudi oil wells, the monarchy, and the sovereignty of the kingdom. In return, the kingdom agreed to invest the dollar proceeds of its oil sales in U.S. Treasuries, basically financing America’s future federal expenditures.

Soon, other members of the Organization of Petroleum Exporting Countries followed suit, and the U.S. dollar became the standard by which oil was to be traded internationally. For Saudi Arabia, the deal made perfect sense, not only by protecting the regime but also by providing a safe, liquid market in which to invest its enormous oil-sale proceeds, known as petrodollars. The U.S. benefited, as well, by neutralizing oil as an economic weapon. The agreement enabled the U.S. to print dollars with little adverse effect on interest rates, thereby facilitating consistent U.S. economic growth over the subsequent decades.

An important consequence was that oil-importing nations would be required to hold large amounts of U.S. dollars in reserve in order to purchase oil, underpinning dollar demand. This essentially guaranteed a strong dollar and low U.S. interest rates for a generation. Given this backdrop, one can better understand many subsequent U.S. foreign-policy moves involving the Middle East and other oil-producing regions.

Recent developments in technology and geopolitics, however, have already ignited a process to bring an end to the financial system predicated on petrodollars, which will have a profound impact on global financial markets. The 40-year equilibrium of this system is being dismantled by the exponential growth of technology, which will have a bearish impact on both supply and demand of petroleum. Moreover, the system no longer is in the best interest of key participants in the global oil trade. These developments have begun to exert influence on financial markets and will only grow over time. The upheaval of the petrodollar recycling system will trigger a resurgence of volatility and new price trends, which will lead to a renaissance in macro investing.

Let’s examine these developments in more detail. First, technology is affecting the energy markets dramatically, and this impact is growing exponentially. The pattern-seeking human mind is built for an observable linear universe, but has cognitive difficulty recognizing and understanding the impact of exponential growth.

Paralleling Moore’s Law, the current growth rate of new technologies roughly doubles every two years. In the transportation sector, the global penetration rate of electric vehicles, or EVs, was 1% at the end of 2016 and is now probably about 1.5%. However, a doubling every two years of this level of usage should lead to an automobile market that primarily consists of EVs in approximately 12 years, reducing gasoline demand and international oil revenue to a degree that today would seem unfathomable to the linear-thinking mind. Yes, the world is changing—rapidly.

Alternative energy sources (solar power, wind, and such) also are well into their exponential growth curves, and are even ahead of EVs in this regard. Based on growth curves of other recent technologies, and due to similar growth rates in battery technology and pricing, it is likely that solar power will supplant petroleum in a vast portion of nontransportation sectors in about a decade. Albert Einstein is rumored to have described compound interest (another form of exponential growth) as the most powerful force in the universe. This is real change.

The growth of U.S. oil production due to new technologies such as hydraulic fracturing and horizontal drilling has both reduced the U.S. need for foreign sources of oil and led to lower global oil prices. With the U.S. economy more self-reliant for its oil consumption, reduced purchases of foreign oil have led to a drop in the revenues of oil-producing nations and by extension, lower international demand for Treasuries and U.S. dollars.

ANOTHER MAJOR SECULAR CHANGE that is under way in the oil market comes from the geopolitical arena. China, now the world’s largest importer of oil, is no longer comfortable purchasing oil in a currency over which it has no control, and has taken the following steps that allow it to circumvent the use of the U.S. dollar:
  • China has agreed with Russia to purchase Russian oil and natural gas in yuan.
  • As an example of China’s newfound power to influence oil exporters, China has persuaded Angola (the world’s second-largest oil exporter to China) to accept the yuan as legal tender, evidence of efforts made by Beijing to speed up internationalization of the yuan. The incredible growth rates of the Chinese economy and its thirst for oil have endowed it with tremendous negotiating strength that has led, and will lead, other countries to cater to China’s needs at the expense of their historical client, the U.S.
  • China is set to launch an oil exchange by the end of the year that is to be settled in yuan. Note that in conjunction with the existing Shanghai Gold Exchange, also denominated in yuan, any country will now be able to trade and hedge oil, circumventing U.S. dollar transactions, with the flexibility to take payment in yuan or gold, or exchange gold into any global currency.
  • As China further forges relationships through its One Belt, One Road initiative, it will surely pull other exporters into its orbit to secure a reliable flow of supplies from multiple sources, while pressuring the terms of the trade to exclude the U.S. dollar.
The world’s second-largest oil exporter, Russia, is currently under sanctions imposed by the U.S. and European Union, and has made clear moves toward circumventing the dollar in oil and international trade. In addition to agreeing to sell oil and natural gas to China in exchange for yuan, Russia recently announced that all financial transactions conducted in Russian seaports will now be made in rubles, replacing dollars, according to Russian state news outlet RT. Clearly, there is a concerted effort from the East to reset the economic world order.

ALL OF THESE DEVELOPMENTS leave global financial markets vulnerable to a paradigm shift that has recently begun. In meetings with fund managers, asset allocators, and analysts, I have found a virtually universal view that macro investing—investing based on global macroeconomic and political, not security-specific trends—is dead, fueled by investor money exiting the space due to poor returns and historically high fees in relation to performance. This is what traders refer to as capitulation. It occurs when most market participants can’t take advantage of a promising opportunity due to losses, lack of dry powder, or a psychological inability to proceed because of recency bias.

A current generational low in volatility across a wide spectrum of asset classes is another indicator that the market doesn’t see a paradigm shift coming. This suggests that current volatility is expressing a full discounting of stale fundamental inputs and not adequately pricing in the potential of likely disruptive events.

THE FEDERAL RESERVE is now in the beginning stages of a shift toward “normalization,” which will lead to diminished support for the U.S. Treasury market. The Fed’s total assets stand at approximately $4.5 trillion, or five times what they were prior to the financial crisis of 2008-09. The goal of the Fed is to “unwind” this enormous balance sheet with minimal market disruption. This is a high-wire act a thousand feet in the air without a safety net or prior practice. Additionally, at some not-so-distant future date, the U.S. will need to finance enormous and growing entitlement programs, and our historical international sources for that financing will no longer be willing to support us in that endeavor.

The market participants with whom I met theoretically could have the ability to accept cognitively the points made in this article. But the accumulation of many small losses in a low-volatility and generally trendless market has robbed them of confidence and the psychological balance to embrace any new paradigm proactively. They are frozen with fear that the lower- return profile of recent years is permanent—ironic in an industry that is paid to capture price changes in a cyclical world.

One market legend with whom I spoke suggested he wouldn’t have had the success he enjoyed in his career had he begun in the past decade. Whether or not this might be true, it doesn’t mean that recent lower returns are to be extrapolated into the future, especially when these subpar returns occurred during the quantitative-easing era, a period that is an anomaly.

I have been fortunate to ride substantial bets on big trends, earning high risk-adjusted returns using time-tested techniques for exploiting these trends. Additionally, I have had the luxury of not participating actively full-time in macro investing during this difficult period. Both factors might give me perspective. I regard this as an extraordinarily opportune moment for those able to shed timeworn, archaic assumptions of market behavior and boldly return to the roots of macro investing.

The opportunity is reminiscent of the story told by Stanley Druckenmiller, who was promoted early in his investment career to head equity research at a time when his co-workers had vastly more experience than he did. His director of investments informed him that his promotion owed to the same reason they send 18-year-olds to war; they are too dumb to know not to charge. The “winners” under the paradigm now unfolding will be market participants able to disregard stale, anomalous concepts, and charge.

RELATEDLY, THERE IS a running debate as to whether trend-following is a dying strategy. There is plenty of anecdotal evidence that short-term and mean-reversion trading is more in vogue in today’s markets (think quant funds and “prop” shops). Additionally, the popularity of passive investing signals an unwillingness to invest in “idea generation,” or alpha. These developments represent a full capitulation of trend following and macro trading.

Ironically, many market players who wrongly anticipated a turn in recent years to a more positive environment for macro and trend-following are throwing in the towel. The key difference is that now there is a clear catalyst to trigger the start of the pendulum swinging back to a fertile macro/trend-following trading environment.

As my mentor, Bruce Kovner [the founder of Caxton Associates] used to say, “Nobody rings a bell at key turning points.” The ability to properly anticipate change is predicated upon detached analysis of fundamental information, applying that information to imagine a plausible world different from today’s, understanding how new data points fit (or don’t fit) into that world, and adjusting accordingly. Ideally, this process leads to an “aha!” moment, and the idea crystallizes into a clear vision. The thesis proposed here is one such vision.
John Curran has written a lot of food for thought in this comment which admittedly is also a bit self-serving, but let me quickly go over some of my thoughts.

First, I don't buy the nonsense of the "end of the petrodollars". This is pure nonsense and all this talk of alternative exchanges that will threaten the preeminence of the US dollar or US exchanges is beyond ridiculous.

 I suggest Mr. Curran and all of you who buy into this nonsense read Yannis Varoufakis's first book, The Global Minotaur. Let me be clear, I'm no fan of Varoufakis and his pompous leftist nonsense but this book is a must-read to understand why the US is gaining global strength as its national debt mushrooms.

In short, the US runs a current account deficit for years but it benefits from a capital account surplus as all those countries running current account surpluses (China, Germany, Japan, etc) recycle their profits back into the US financial system, buying up stocks, bonds, real estate and other investments as well as subsidizing the US military industrial complex.

The second book I want you all to read is John Perkins's The New Confessions of an Economic Hitman, an expanded edition of his classic bestseller. You will learn the world doesn't work according to some nice, tidy economic model full of complicated equations. Behind the scenes, there are a lot of dirty things going on.

Importantly, and this is my point, the US dominates global finance and the global economy, which is why I scoff at the idea of China, Russia or any other country is gaining on it and threatens to displace it or displace the greenback as the world's reserve currency.

Is China important? Absolutely. But make no mistake, the US exerts immense power over China and other countries and it leads the world, not the other way around.

And China has its own internal problems right now. Over the weekend, I read about how China’s mortgage debt bubble raises spectre of 2007 US crisis and why Jim Rickards thinks we need to prepare for a Chinese Maxi-devaluation.

Remember, it was a little over two years ago that China's Big Bang rocked markets, clobbering risk assets across the spectrum.

Is it possible that another Chinese devaluation is coming? It's unlikely now but if the US dollar continues to appreciate from these levels, which is one of my macro calls, I certainly think it's a definite risk.

Why should we care if China devalues again in a significant way? Because it will heighten global deflation at a time when deflation already threatens the US and a time when global inflation is in freefall.

Importantly, the last thing the world needs right now is for China to devalue its currency, it will wreak havoc in emerging markets and heighten global deflationary headwinds at a time when the world is at risk of entering a long period of debt deflation.

[Note: China devaluing puts pressure on Asian emerging markets to devalue their currencies and on Japan to devalue its yen, flooding the world with cheap goods, effectively exporting more goods deflation to developed nations which are already highly indebted and unlikely to keep buying cheaper goods indefinitely.]

This brings me back to John Curran's comment above. I agree, there is a technological revolution going on in energy which is deflationary and will cap and lower the price of oil over the long run. The Saudis aren't stupid, they see the writing on the wall which is why they're planning to sell part of Saudi Aramco.

And where do you think Saudi Arabia will invest its proceeds to diversify its economy away from oil revenues? You guessed it, global stocks, bonds, real estate, private equity, and infrastructure and it will invest primarily in the US using US banks and funds.

Now, let me tackle this part of John Curran's article:
The Federal Reserve is now in the beginning stages of a shift toward “normalization,” which will lead to diminished support for the U.S. Treasury market. The Fed’s total assets stand at approximately $4.5 trillion, or five times what they were prior to the financial crisis of 2008-09. The goal of the Fed is to “unwind” this enormous balance sheet with minimal market disruption. This is a high-wire act a thousand feet in the air without a safety net or prior practice. Additionally, at some not-so-distant future date, the U.S. will need to finance enormous and growing entitlement programs, and our historical international sources for that financing will no longer be willing to support us in that endeavor.

The market participants with whom I met theoretically could have the ability to accept cognitively the points made in this article. But the accumulation of many small losses in a low-volatility and generally trendless market has robbed them of confidence and the psychological balance to embrace any new paradigm proactively. They are frozen with fear that the lower- return profile of recent years is permanent—ironic in an industry that is paid to capture price changes in a cyclical world.

One market legend with whom I spoke suggested he wouldn’t have had the success he enjoyed in his career had he begun in the past decade. Whether or not this might be true, it doesn’t mean that recent lower returns are to be extrapolated into the future, especially when these subpar returns occurred during the quantitative-easing era, a period that is an anomaly.
I used to invest in top macro funds all over the world and one of my biggest pet peeves was lame excuses for underperformance. "The Fed and other central banks are distorting financial markets and this will come to an abrupt end."

Really? Why? Because you say so as you collect a big, fat 2% management fee on billions as you severely underperform these markets? I've been waiting for years for your theory on central banks "blowing up" to come to fruition and so far, you've been wrong and it cost me potential returns elsewhere as you collect a management fee on billions.

I read Charles Hugh Smith's comment on the endgame of financialization being stealth nationalization where he posted this chart (click on image):


So what? We all know Janet in Wonderland and her global colleagues are buying up assets like crazy, enriching bankers and their elite hedge fund and private equity clients.

What I want to know is whether there are limits to central bankers' prowess? I asked one astute hedge fund manager this very question and he replied:
"The limits to CB prowess are now in full manifestation via political+social volatility.  It is this apparent and rising political and social volatility which is forcing central banks to shift from expansion to contraction of their aggregate balance sheets."
I'm hardly convinced this is why central banks are shifting gears. In fact, I firmly believe the Fed knows deflation is headed for the US and it's trying to store up ammunition as fast as possible to help shore up big banks and prepare for the next financial crisis.

It's a big gamble. Why? Because the Fed only controls the short end of the curve, not the long end which is primarily influenced by inflation expectations which keep dropping. And the irony is that as the Fed tightens and raises rates, it's accelerating this drop in inflation expectations, further stoking deflationary headwinds here and around the world.

This is why BlackRock's Larry Fink is warning of the risk of an inverted bond yield curve:
The head of the world’s largest asset management company said investors’ appetite for those assets could move long-dated yields below those of shorter-term debt.

That condition, known as an inverted yield curve, is often considered a precursor to recession and could presage a decline for stocks.

“If there is a risk, it’s that,” Fink said in an interview. “I hope the Federal Reserve pays attention.”

However, he said he did not see an inverted yield curve materializing within the next year as global economic growth accelerates.
Larry is dreaming if he thinks global economic growth is set to accelerate. I know that's what BlackRock is hoping for but the opposite will happen.

This brings me to my final point on the coming renaissance of macro investing. As bond traders face an inflation gamble that will last a generation, they better get it right, because if they don't, it will cost them dearly.

The link between asset inflation/ bubbles and the real economy is what worries me as this crazy stock market keeps punishing sellers. Now more than ever, you need to be very careful navigating though these prickly markets.

As I stated in my last comment on why the bubble economy is set to burst, downside risks are mounting:
Nothing can stop these central bank-controlled markets. Janet in Wonderland and her global colleagues are in control (or so they want you to think), which is why Jim Chanos and other short-sellers are losing money this year as markets melt up.

Is it time to party like it's 1999? Are we on the cusp of a major parabolic market breakout that will last a couple of more years?

Before you get all excited, let me share with you what one astute hedge fund manager I know, Dimitri Chalvasiotis, sent me last Friday after the close:

Volatility Adjusted SP500, as of Friday’s closing metrics, has reached an historic extreme printed a handful of times since 1971. In other words, going forward, either SP500 declines in value or SP500 realized volatility rises. Rare (mathematical) juncture in time/price (click on image).

In other words, get ready for some rock 'n roll, the silence of the VIX won't last forever, and even if markets keep melting up, all that's happening is downside risks are mounting.
So, I do agree with John Curran on one point, those who foolishly think global macro is dead are wrong. It's not dead but the problem is markets can stay irrational (thanks to central banks) longer than macro gods who are in big trouble can stay solvent.

On that note, Bloomberg's Nishant Kumar reports Brevan Howard Asset Management, the hedge fund firm co-founded by Alan Howard that’s battling an investor exodus, is planning to start two more funds, including one that is betting on volatility in the Treasuries market.

The only volatility I foresee in US Treasuries is upside volatilty in prices as yields plunge to a new secular low, sending US long bond prices (TLT) to record highs.

And Canada’s housing market is “ripe for a pretty severe correction” with Canadian Imperial Bank of Commerce the most vulnerable, according to the Big Short's Steve Eisman, a fund manager at Neuberger Berman Group LLC.

You already know I thought the Bank of Canada was flirting with disaster raising interest rates earlier this year but it seems to have backed off for now. Eisman is right to note Canada hasn't had its credit cycle yet and it's about to have one. Read Ted Carmichael's latest global macro comment to understand why Canada's credit cycle downturn is coming (keep shorting that overvalued loonie).

This is hardly news to those of us who have been warning of Canada's growing debt risks but speculation on houses continues, including here in Montreal where bidding wars are breaking out in nice neightborhoods "rich" Chinese seek to move to (as long as your house has good feng shui).

Those poor Chinese and Canadians buying houses now are in for a rude awakening and all the feng shui in the world won't help them recover the losses they will suffer over the next decade.

The coming renaissance of macro investing? Maybe but only the best will survive the coming shakeout in the hedge fund industry.