Multiple Expansion and Two Markets to “Three Markets” – The High Risks to Small Investors

In his legendary book A Margin of Safety, Seth Klarman explains what few investors can remember when times are good. Specifically:

“A corollary to the importance of compounding is that it is very difficult to recover from even one large loss, which could literally destroy all at once the beneficial effects of many years of investment success. … An investor who earns 16% annual returns over a decade, for example, will, perhaps surprisingly, end up with more money than an investor who earns 20% a year for nine years and then loses 15% the tenth year.” –page 83

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For doubters of that last sentence, we have rebuilt Mr. Klarman’s wisdom in a simple bar chart.

The Incredible Power of Capital Preservation

We have written a great deal about Buffett’s favorite valuation metric, Market Cap to GDP. In that post we showed the remarkable long run predictive ability of this indicator. With the R2 at 0.80 for the subsequent decade’s annual returns, it has done better than the more popular and better-known Shiller PE.

Market Cap to GDP Updated

Despite the nominal decline in the indexes, the market is still more expensive than it was at the peak. As valuations ballooned due to multiple expansion, we noted that this phenomena was concentrated in the market’s “glamour stocks” while other more prosaic, proven and profitable stocks became ever cheaper on a relative basis.

Private Equity Performance Reporting

That was the tale of two markets. We would note that none of the market cap held in private equity funds and venture capital is included in that chart above. That line would be far higher if we included all the market cap that is currently sitting in the hands of private equity.

We felt certain that the implosion of WeDon’tWork would bring the lemmings playing “hot potato” with companies’ valuations in the private market to a screeching halt. We were wrong. Note: “WeDon’tWork” is a term of art coined by the brilliant Michael Lewitt in his must-read letter The Credit Strategist.

We cited work by professor Gregory Brown of UNC’s Kenan-Flagler Business School, who used a proprietary data set working with private equity firms to suggest the asset class was crowded. In our work, we highlighted that debt to EBITDA ratios and valuations in the private space had eclipsed any historical precedent by a wide margin.

The professor’s analysis highlighted that the valuation methods to calculate “adjusted” EBITDA had veered into the absurd. As a non-GAAP figure, these EBITDA calculations now include novel add backs for unrealized future synergies – further invalidating the number as a proxy for free cash flow.

Private Equity IRRs:

We went on to discuss work from Cliff Asness’ legendary AQR explaining how the reported risk for those invested in private equity was a total chimera. Their work explained how private company valuations were actually being inflated due to a preference for “artificially smooth returns.” For the institutional investors with actuarial obligations who are often the big, limited partners in these funds, the appeal of lower reported volatility is obvious.

Our research added to a growing amount of evidence that both the reported returns and volatility in the private space defied basic arithmetic concepts. This article in the FT for example cited work from an academic showing that Yale’s claimed IRRs in private equity were simply impossible. Professors from UVA’s Darden Business School published findings showing that when calculated honestly, in the period following 2006, the returns to private equity industry averages had merely kept up with the market despite much higher leverage.

One could suggest private equity valuations are the “third market.” Unable to list at the desired valuations in the IPO market, private funds fed a SPAC frenzy which has already imploded. Unable to source capital from retail investors via IPOs or SPACs, these hyped-up companies are now finding that their bloated valuations – once used as a recruiting tool – have now become a liability.

Private Equity Valuations: The “Third Market”

News has hit this morning explaining that Instacart just cut its valuation by 40% from $48bn to “only” $24bn. Part of the rationale? “The San Francisco-based startup, whose investors include Andreessen Horowitz and Sequoia Capital, hopes the move will help it attract and retain talent in a tight U.S. labor market by aligning new equity awards with the updated valuation.” The very employees they want to hire using equity knew the valuation was too high.

A Pandemic darling, Instacart generated only $1.8bn in revenues in 2021 and barely turned a profit. Think about that.

Investors in Instacart had the wonderful experience of watching their investment value show virtually zero downside volatility while the valuation was relentlessly marked higher. And suddenly – poof. Down 40%.

To state the obvious, at $24bn the stock is still over 10x the company’s 2021 sales. That’s a valuation we have repeatedly explained is unjustifiable for any business. That price is even less appealing for a food delivery service that struggles to make a profit.

If Instacart was public would we not be inundated with analogies to Webvan? Did something change between 1999 and today that makes delivering food a much better business?

So why does this matter?? As Bloomberg Law recently reported, private equity firms are winning the fight to get into 401k plans. This strikes us as entirely counterintuitive.

With Private Equity firms drowning in record breaking levels of “dry powder” in what may be the most crowded trade ever, why would they want access to retail investors retirement money? Does private equity have too much money? Or not enough?

A cynic might suggest that seeing the IPO and SPAC markets rebuking the ludicrous valuations ascribed to many portfolio companies, private equity is looking for “new money.” With returns generated by internally marked valuations that often show little if any downside volatility, these funds will be very easy to sell, and the enormous fees create a large incentive for them to be sold.

Unfortunately, as Barron’s explained, this could be a seriously suboptimal strategy for small retirement investors lured in by high reported rates of return. Citing work by Harvard Business School professor Erik Stafford’s research, they show that private equity has lagged a simple index of small value stocks.

Softbank’s own Rajeev Misra, the head of the Vision Fund, explained that many private market valuations are higher than their public market peers. It certainly looks to us like the move to get access to retirement accounts may simply be an attempt to create liquidity around portfolio companies held at prices that cannot survive public scrutiny, much less public markets.

Lastly, I’d like to note that under the “watch what someone does rather than what they say” rule, private equity firms are sending a powerful signal. For those of us who have been at this a long time, Blackstone’s decision to IPO in June of 2007 was a legendary signal of just nailing the peak of the market.

The firm listed immediately prior to the mortgage crisis that would seize debt markets and send the equity market crashing lower. It took investors in Blackstone’s IPO five years to break even, and a full decade later they had earned a paltry 2.5% annual return while suffering enormous volatility.

Look at the news today. The buyout firm PAG backed by, yup, Blackstone, is looking to raise $2bn in an IPO valuing the firm at $10bn-$15bn. And they are not alone. As Bloomberg News and other financial media have highlighted, private equity firms everywhere are heading for the exits.

At this point, TPG, Bridgepoint Group PLC, Blue Owl Capital Inc. and myriad others have already gone public. There is a growing line of others heading for the exits. As the Financial Times noted in their phenomenal article Inside Private Equity’s Race to Go Public, “The developing consensus … is to cash in while valuations are high.

As always. Buyer beware…..

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.



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April 4, 2022 |

Categories: Rants & Raves

April 4, 2022

Categories: Rants & Raves

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