Ted Honored with ‘Citizen of the Year’ Award

Kip McDaniel’s With Intelligence held its first Allocator Prizes dinner, at which Ted received the industry’s ‘Citizen of the Year’ award for"exceptional contributions to the institutional investor community and visibility of its best people, work, and practices." We have you to thank for your time and engagement that led to this honor.

When There’s No L in LBO

Once upon a time, Michael Milken catalyzed the modern private equity industry by financing leveraged buyouts (LBOs) with below-investment-grade bonds. Market participants dubbed the paper “junk bonds” in the heyday of the 1980s. Much like less-marketable financial conventions like “death insurance” and “passive investing,” the moniker “junk bonds” did not resonate with all comers.[1] The euphemism “high yield bonds” sounded a lot better, as did “private equity” for those afraid of leverage.

At times, “high” was not an apt description for the yield on below-investment-grade bonds. Yield spreads compressed in the run-up to the GFC, when troubled issues without protective covenants revealed many were junky after all. More recently, low interest rates made the “high” in “high yield” true only in relative terms.

Despite a few quirks in terminology, high-yield bonds and their cousin, leveraged loans, supported a surge in private equity activity over the last thirty years. Returns on those deals far surpassed investor needs.

Where’s the L in LBO?

My conversations on our new show, Private Equity Deals, discuss portfolio companies and recent exits. Some of the conversations with mega-cap private equity firms like KKR and Thoma Bravo cover companies purchased and sold at mid-teens to twenties EBITDA multiples. The prices seem high, but private equity firms have found lots of ways to create value and deliver.[2]

A funny thing happened on the way to launching Private Equity Deals. While I was cognizant of risk coming from high purchase prices and rising interest rates, I missed a significant change in the capital structure of private companies. The LBO has gone away in place of, well, private equity. A glimpse under the covers reveals there’s a lot less L. Leverage has not kept up with rising asset prices in mega cap deals. A similar business that may have sold for 10x EBITDA a decade ago would transact 20x EBITDA today, at least until recently. Lenders extended credit lines from 6 to 7 turns of leverage, but they have not increased debt pro rata with the increase in equity invested by sponsors. What was once an LBO with 40% equity/60% debt now is buyout financed with 60% equity/40% debt.

The middle market has seen a muted version of the same trend. My friends at Fund Evaluation Group shared data showing that middle market purchase multiples rose around 30% over the last decade from 9x to 11.5x EBITDA. Lenders extended from 4.5x to 5.0x, leaving equity sponsors increasing their contributions from 50% of the capital structure to 65%.

As we peer into the abyss of rising rates, inflation, and a potential recession, the increased equitization of privately owned businesses has implications for company fundamentals, valuation, and investment risk.

Operating Fundamentals

Financial leverage works both ways in magnifying operating results. When a business performs, higher leverage enhances returns and conversely, lower leverage decreases returns. In this lower leveraged environment, sponsors will need to rely on continued growth and operational improvement at portfolio companies to meet return hurdles, even in the face of a more challenging macroeconomic headwinds.

On the other hand, in difficult periods, lower leverage mitigates the downside. Companies with a larger equity cushion may have more operational flexibility to weather the storm and play offense. Additionally, for all the noise about lagged private equity marks manufacturing low return volatility, less leverage actually does reduce the volatility of private equity strategies.

Time and again, private equity managers have found different levers to drive operational excellence. KKR increased engagement and productivity through employee ownership at CHI Overhead Doors. Thoma Bravo installed a newly motivated management team at RealPage, and Stone Point opened new sales channels for Bullhorn as the fifth private equity owner of the business. Each succeeded by growing the top line and improving margins without significant financial leverage.

The more subtle dynamic at play is the confluence of a lower leverage ratio with an increase in debt outstanding. No matter how much equity a sponsor invests, the business still must support a higher debt load and rising interest costs with the same cash flow. That hasn’t been an issue for a long time, but it may become one in a downturn.

Business Valuation

Rising purchase prices expose portfolio companies to the risk of multiple compression unlike any the private equity industry has experienced. Valuations over the decades have risen without as much as a blip. Even without an economic downturn, the industry may discover it has resembled a frog in a slowly boiling pot of water.

The public market selloff suggests the pricing environment has changed. In response, the private markets are showing signs of weakness through a slowdown in deal activity, widening of bid-ask spreads, and lack of price discovery. Valuations are on the cusp of a repricing.

Risk

Owners and lenders are assessing risk differently. Private equity managers have sought a return on capital by embracing the impact of technology on growth and profitability to catalyze a step-change increase in business quality. Lenders have sought a return of capital by ensuring the existing cash flows of the business support the interest expense. In the end, only one will have accurately calibrated risk.

Should fundamentals deteriorate, the battle between lenders and sponsors in a restructuring will be one to watch. In the 2008 crisis, many private equity sponsors took advantage of weak debt covenants created by banks to kick the can down the road, preserve the option value of their equity, and avoid defaults. This time around, lenders are primarily sophisticated private credit managers that know sponsors have both a lot to lose and plenty of dry powder to support struggling portfolio companies. The bargaining power in a negotiated restructuring may be more balanced than in the past.

Where do we go from here?

Thirty years ago, junk bonds and corporate raiders embodied by Gordon Gekko inspired a future generation of dealmakers that reshaped companies around the world. Their impressive work inspired a generation of allocators to plow hundreds of billions of dollars into private market strategies. That supply of capital drove an increase in equity check sizes that left the L in LBO behind.

Today, higher purchase multiples, increased financing costs, and slower growth present headwinds for private equity managers to produce similar returns to what investors have enjoyed for decades. If a business can support its debt, returns will be muted by the large amount of equity invested in deals. If not, we’ve got a real problem.

Then again, private equity firms have done a fabulous job improving businesses for a long time. Maybe they can pull yet another rabbit out of their hat. So will private equity managers continue to spin straw into gold, muddle through as companies grow into their valuation, or be left dealing with a pile of junk?


[1] Catch phrases in investing are an important driver of fund flows. See What’s In A Name? The Problem With ESG for a recent example.

[2] I wrote The Day of Reckoning for Private Equity two years ago predicting the freight train would stop. I was either early or wrong, although the data so far only supports the later.

The Definition of Poor Governance

“You can’t have investment success with a bad governance structure.” - Karl Scheer

The headline in Institutional Investor reads “‘Everyone Was Shocked’: Investment Committee Members Resign After Hartford HealthCare Fires Staff, Hires Morgan Stanley.

A friend of mine and past guest on Capital Allocators is (sorry, was) a member of that Investment Committee. The headline rings true. The Board canned a highly respected and high-performing CIO, David Holmgren, and his entire investment team without as much as a peep to the team, its knowledgeable investment committee, or even the IC Chair.

Did that just happen?

Governance is the most frequent topic that arises when I give fireside chats. It even came up last week at the annual meeting of consultant Marquette Associates. It is the topic whose gravity most surprised me when I kicked off the podcast five years ago, and it is the topic so screaming for knowledge transfer that I wrote a chapter in Capital Allocators with a framework to get it right.

And yet, I can only surmise that somehow a Board comprised of doctors and healthcare professionals ignored its successful investment team and committee and handed $4.3 billion over to Morgan Stanley because, maybe, someone on the Board had a friend, and well…

Just when you think you’ve seen it all, the dictionary/wiki definition of “Poor Governance” just added a new headline. It’s atrocious.

Good governance is far easier to describe than implement, but apparently ridiculous governance still happens. For the next naïve Board, I offer a Cliff’s Notes version of Chapter 6 in Capital Allocators. I hope it helps one reader avoid the kind of mistake that hurts beneficiaries for years to come:

Align compensation structure of the team with the goals of the institution

In my thinking about governance, I only considered the interaction between an investment committee and investment team. If I had a chance to address the Hartford HealthCare Board, I would have added one admonishment: when you have a good thing going, stay out of the way!

Dakota Live!

In this interview, Ted discusses some of the most notable themes and guests of the Capital Allocators podcast. Watch the interview here.

LIV Golf is Asset Management in Reverse

The world of professional golf is ablaze with a new competitive threat to the established PGA Tour. Backed by funds from the Saudi Sovereign Wealth Fund and insights from former professional and savvy businessman Greg Norman, LIV Golf is plowing $1 billion into wooing golfers to compete on their new tour.

Golf may seem irrelevant to asset management. In fact, it’s been nine years since I wrote about golf,  drawing lessons from the sport about when to sell a fund manager. However, the LIV Tour made headlines for both its Saudi backing and its compensation structure. The backing shines a renewed light on Saudi Arabia’s human rights abuses, but were it not the Saudis, someone else would have created the LIV Tour. That’s the nature of free market competition against an entrenched monopoly. The compensation structure is what is really gaining traction.

The compensation structure of the two golf organizations parallels models in asset management - where it has been (LIV) and where it is going (PGA). Ironically, golf is moving in the opposite direction.

The PGA Tour is the epitome of pay-for-performance, akin to incentive fees in asset management. Golfers earn money only through excellence. A typical tour event lasts four days. After two days, the top of the field “makes the cut” and plays the last two days.[1] Any golfer that misses the cut does not earn a dime. At the end of four days, golfers are paid based on their place of finish for the week. Many golfers have resumes that indicate excellence,[2] but only the very best among them earn a living in the sport.

LIV Golf introduced appearance fees, akin to management fees in our industry. Players who sign up for the tour are paid to play handsomely irrespective of their result on the course. The compensation structure is great for golfers, as they gain stability of income and potentially a greater chance to weather performance volatility. Additionally, players ranked below the upper echelons gain resources to invest in their future.[3]

The interesting question that arises is not whether the LIV Golf compensation structure (or management fee income) is good for the players (or money managers). It is whether the scheme is good for results (of both golfers and money managers). Traditional asset management is typically a management fee-only business. Managers grow assets to boost profits for the asset manager, knowing full well that size is the enemy of performance. We’ve all seen studies that show the industry in aggregate has failed to deliver for clients net of fees, while many money managers enriched themselves in the process.

Alternative asset managers changed the compensation structure. Once cottage industries, hedge fund, venture capital, private equity, and other alternative managers created businesses where management fees covered expenses and incentives accrued only with performance, aligning their interests with their clients. Of course, no one realized thirty years ago that alternatives would go mainstream and management fees would become a massive profit center for large managers as well, but that’s a separate issue.

The trend of compensation structures in asset management is the opposite of golf. Over time, assets in sub-optimal fee structures are shifting towards incentive-based rewards and away from fixed management fees. The industry is too mature with legacy agreements between managers and clients for this to happen quickly, but the trend is the allocator’s friend.

What happens with the LIV Tour will be fascinating to watch. Golfers need some stability to maximize their performance, but it remains to be seen whether that stability allows a golfer to relax and sink a clutch putt or causes them to lose their competitive edge. And what can we infer about the golfers who eschew guarantees in favor of performance-only compensation?

My take: Incentives matter. The LIV tour will continue to expand and take share from the PGA, as golfers experience the benefits of certainty for their pocketbooks. Golf scores will get worse. Stable income is good for golfers, but I’m in favor of money management moving towards the PGA’s way of doing business.


[1] Technically, the standard cut line for a PGA event after two rounds is the score of the 65th lowest scoring professional (where lower scores are better in the sport).

[2] Those with ‘scratch’ or ‘plus’ handicaps. A golf handicap is a measure of past performance relative to par, or the number of strokes an expert player would need for a given hole. A scratch handicap is roughly equivalent to par and a plus handicap is better than par.

[3] A concept similar to that created by Michael Schwimer for minor league baseball players in Big League Advance. Listen to Moneyball as an Investment Strategy to learn more.

Ted's Top Reads

To compound knowledge and relationships with our Premium members, we are sharing a list of Ted’s favorite reads. These are investing blogs, investment news, and interdisciplinary blogs that the Capital Allocators team read to keep up to date on professional best practices. Access the list here.

Opto Sessions

In this podcast, Ted discusses how he interviews money managers to find out their secrets to success. Listen Here

Outside In with Jon Lukomnik

Ted appeared on the podcast to discuss finding that manager who so blows you away on every level, learnings from his bet with Buffett, generating investing success and giving to charity. Watch the episode Here.

Capital Allocators Monthly - June 2022

"The cure for anything is salt water: sweat, tears, or the sea."

- Isak Dinesen
Announcements
CAU Decision Making Bootcamp. Join us for a one-hour bootcamp on decision
making, one of the most popular classes of Capital Allocators University.

Ted will teach actionable frameworks with special clips from Annie Duke. You'll learn tips to take back to your teams in the investment office.

The bootcamp will be held on Wednesday, July 20th at 11 AM ET. The cost to attend is $250, and Capital Allocators premium members will receive a 50% discount.

If you’re interested in attending and are not yet a premium member, you may want to consider subscribing first and receive our library of transcripts, weekly newsletter, and a whole bunch more (for effectively half off the first year of membership!).
Register for Bootcamp
Premium Sample
Capital Allocators Premium members receive transcripts, gatherings with show guests, weekly email, and early access to Ted's investment blog and Hot Jobs.
History Rhymes with the Downturn. "History Doesn’t Repeat Itself, but it Often Rhymes." This famous expression (never actually said by Mark Twain) is frequently cited when trying to map the market terrain. The current downturn is no exception, with verses that rhyme with aspects of both the tech wreck in 2000 and the financial crisis in 2008.

The potential for revolutionary technology drove the market to price decades of progress in advance for the internet in 1998-2000 and crypto from 2020-2022. An economic contraction in part caused by leverage in the financial system followed the market crash in 2008 and may lurk below the surface again today. While it’s too soon to know the final stanza of this story, highlighting the past and potential paths forward help keep us centered in turbulent times.
Read Ted's Blog & Subscribe to Premium
A Word from our Sponsor
Anchorage Digital. We are grateful to Anchorage Digital for sponsoring Crypto for Institutions 2! As the most advanced crypto platform for institutions, Anchorage Digital is the premier crypto partner. Featuring unparalleled security, Anchorage offers custody, trading, financing, staking, governance, and the first federally chartered digital asset bank. With support for a wide variety of digital assets, Anchorage is trusted by hedge funds, venture capital firms, banks, family offices, fintechs, treasuries, and asset managers. Some of the largest names in finance have announced their path into crypto by investing in Anchorage Digital — Anchorage raised $430M last year, bringing the company’s valuation to over $3B.
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Hot Jobs to Share
Reminder to check out our new job board for previously shared positions. For employers, send interesting opportunities to team@capitalallocators.com. For job hunters, Premium members get an early look at these Hot Jobs before the rest of the crowd!

Annie E. Casey Foundation. The foundation is looking for an investment analyst to help manage a $2.4 billion global portfolio of marketable investments.


GuideStone Financial Resources. The Dallas-based fund is seeking an Associate Portfolio Manager to lead the research and asset allocation activities.


Local Pensions Partnership Investments. LPPI manages £18.5bn of pension assets for local government pension schemes and is looking to bring on a Senior Analyst for Global Equities.


State of Hawaii EUTF. The state plan is looking for an analyst to work directly with their CIO in managing their multi-billion dollar portfolio.

View Job Board
Reading
Ordered by reading time: tweets first, books last, and blog posts and articles in between.
1. What to Say to Your LPs Right Now. John-Austin Saviano is the former CIO at UC-Berkeley and founder of High Country Advisors. He offers sage advice to GPs on how to communicate in rocky markets, and we're not just saying that because of how closely his thoughts echo Chapter 10 in Ted's book. Read What to Say to Your LPs.
2. Travel Tips from a Former FBI Negotiator. Chris Voss details how negotiating tactics can be applied to landing travel perks. Chris wrote this article in February 2020. We saved it until it is happily relevant again! Read NYT Piece.
3. The Beauty of Enough. Another gem from Sahil Bloom on how to fight back against the perpetual desire for more. Read The Beauty of Enough.
4. State of Crypto. a16z released a web3 primer – from layer 1 and 2 blockchains to DeFi, stablecoins, and NFTs. The overview is a perfect pairing with our Crypto for Institutions 2 mini-series! Read State of Crypto.

5. Net Interest Blog. Marc Rubenstein is a former financials analyst that writes terrific weekly content about the sector. This sample discusses the importance of branding in AUM growth, flowing nicely from Ted's blog post on ESG. Read Net Interest Blog.
Listening

Capital Allocators Episodes

EP.253:  Sam Zell – Common Sense and Uncommon Profits

EP.254:  Marcos Veremis – Allocator’s Perspective on Blockchain (Crypto for Institutions 2, EP.1)

EP.255:  Stephen McKeon – NFTs and the Consumer in Web3 (Crypto for Institutions 2, EP.2)

EP.256:  Ben Forman – Opportunities in DeFi (Crypto for Institutions 2, EP.3)

EP.257:  Olaf Carlson-Wee – The Future of Crypto (Crypto for Institutions 2, EP.4)

EP.258: Chris Dixon – Frameworks and Investing at Scale (Crypto for Institutions 2, EP.5)

EP.259:  Diogo Monica – Securing Crypto at Anchorage Digital (Crypto for Institutions 2, EP.6)

Manager Meetings Episode


EP.32: Leigh Drogen – Quantamental Approach to Crypto at Starkiller Capital
 

History Rhymes with the Downturn

“History Doesn’t Repeat Itself, but it Often Rhymes.”

This famous expression (never actually said by Mark Twain) is frequently cited when trying to map the market terrain. The current downturn is no exception, with verses that rhyme with aspects of both the tech wreck in 2000 and the financial crisis in 2008.

The potential for revolutionary technology drove the market to price decades of progress in advance for the internet in 1998-2000 and crypto from 2020-2022. An economic contraction in part caused by leverage in the financial system followed the market crash in 2008 and may lurk below the surface again today. While it’s too soon to know the final stanza of this story, highlighting the past and potential paths forward help keep us centered in turbulent times.

Parallels with 2000

Innovative technology priced in years of success.

As a part of the run-up to 2000, internet-related businesses sported lofty valuations. Many were unproven ventures that took advantage of a receptive IPO market to raise capital. Once in the public domain, the market irrationally rewarded public companies that added “dot.com” to their name with a 74% pop in share price.[1]

When the tide went out, lots of companies were swimming naked. Many cash burning machines without sustainable business models failed. Among the survivors, some, like Amazon, had sufficient resources to weather the storm. Others, like Google and Facebook, launched later with better timing for their products to harness the growing power of the internet.

The internet changed the face of commerce, but it took a decade or more for the infrastructure and adoption to catch up with the hype. The excitement around the new technology of the internet in 2000 ultimately proved correct. Every business has a website today, even those without “.com” in their name.

Blockchain technology has a similar feel. Fundraising for crypto start-ups was on fire the last few years, and valuations for both private rounds and traded tokens got out of control. I have never seen investment returns across a segment as high as those produced by crypto managers in 2020-2021. Greg Zuckerman wrote a book about John Paulson’s shorting of subprime mortgages in 2007 called The Greatest Trade Ever. The revised edition may have to be called The Second Greatest Trade Ever.[2]

It's too early to know if blockchain technology will be as important as its advocates believe. As the insatiable appetite for funding a crypto future recedes, many crypto projects and companies will go bust. Skeptics will poke fun at the limited number of use cases and prices paid for digital images of apes today, but crypto survivors may find new applications and foster a valuable community around NFTs over the next decade, just as Amazon and its brethren did after 2000. As the underlying blockchain technology and its applications develop, digital wallets and blockchain protocols may become as ubiquitous as email addresses and websites are today.

Overvalued stocks ‘eventually’ experienced multiple compression. 

The dot-com boom had an aura of euphoria that allowed tech stocks to rise to valuations untethered from economic reality. Pets.com epitomized the boom, spending twice as much on a Super Bowl advertisement in 2000 than it made in revenue the prior year.[3] For a while, the tech sector could do no wrong. When market sentiment changed, overvalued stocks crashed to earth.

Growth stocks similarly experienced a decade of outperformance over value until the last few months. A whiff of a different economic future changed the most popular market narrative from growth and return on capital to cash flow and return of capital.

The challenge for market participants, as it was in 2000, is the word “eventually.” Timing markets is notoriously difficult. Skeptics on the way up are often worse off through the cycle after considering opportunity cost. Just ask the value investing community how the last decade has impacted their returns and businesses. It’s a phenomenon I wrote about last year in I Told You So.

Even worse, FOMO is ever present in a bubble, enticing skeptics to join the crowd late in the game. Market maestro Stanley Druckenmiller stopped fighting the tape in 2000 and bought internet stocks late in the game.[4] We’ll soon see which fund managers got whipsawed this time around.

The stock market selloff did not affect the real economy (so far).

The real economic impact of the dot-com crash was limited to the technology sector. Value stocks soared, the economy continued to plug along, and the market pain proved short-lived.

The current situation has been similar until recently. Growth stocks began selling off in November, but businesses continue to show strong fundamentals. While rising inflation is starting to take a toll on cost structures, it has not yet impeded the top line.

Parallels with 2008

The stock market selloff is a leading indicator of a recession.

The market crash in 2008 turned into the Global Financial Crisis with the bankruptcy of Lehman Brothers. That event triggered a freezing of credit markets that caused global economies to fall off a cliff in the fourth quarter of 2008. Economic activity collapsed so quickly that governments resorted to unprecedented stimulus to stave off a depression.

Current economic indicators are worrisome. Should inflation persist, weakness in consumers, businesses, and governments will accelerate, and we could be headed into a recession or worse. We will have to see if this correction ultimately parallels 2000 or 2008.

Leverage in the system exacerbates the downturn.

Financial leverage magnified the impact of the market crash in 2008. Subprime mortgages were a small percentage of the mortgage market, but derivatives on subprime mortgages dramatically increased exposure in the financial system. Corporate balance sheets were highly leveraged as well, relying on robust credit markets to fund operations that proved problematic after the fall of Lehman.

After the GFC, leverage shifted from the hands of the consumer and corporations to governments. Massive stimulus in 2009 and again in 2020 left governments around the world with more debt than ever before. Near zero interest rates for a decade postponed any issues with debt. It remains to be seen what impact the leverage unwind will have on markets and economies.

What I’m Watching

The degree to which the stock and crypto markets follow a path like 2000, 2008, or something new remains to be seen. I am watching trends in inflation and the unwinding of leverage as indicators of the unfolding market challenge.

Inflation

Rising inflation is a consequence of both endogenous cyclical factors from money printing and exogenous pain from war and disease.

  1. Interest rates. Two decades of monetary stimulus would be expected to put pressure on the Fed to raise interest rates and fight inflation. Can the Fed engineer a soft landing?

Leverage

  1. Crypto. Crypto investors point to this downturn as just another wild gyration in prices. However, stories abound that the financial leverage behind crypto tokens exploded since the last crypto winter in 2018 with the ascent of DeFi protocols. Will leverage exacerbate this downturn?

This may be the first time in my career that a significant market event feels like others I have experienced. The story I am telling myself and sharing with you may well say more about my age than my ability to forecast, but I can’t shake the feeling that I’ve heard this song before.


[1] “A Rose.com by Any Other Name.” The Journal of Finance Vol LVI No. 6, December 2001. http://home.business.utah.edu/finmc/FinalJFversion2371-2388.pdf

[2] As an example, Multicoin’s hedge fund generated approximately 10x the returns of Paulson’s subprime fund in 2020-2021.

[3] “From IPO to Complete Liquidation in 268 Days. How Pets.com Became the Biggest Disaster of the Dot-com Bubble.” https://www.celebritynetworth.com/articles/entertainment-articles/took-pets-com-just-268-days-go-ipo-complete-liquidation-thats-disaster/

[4] “How the Soros Funds Lost a Game of Chicken Against Tech Stocks,” Wall Street Journal, May 22, 2000. https://www.wsj.com/articles/SB95894419575853588.