Category Archives: Private equity

Detroit’s city-owned art and alternative investments

July 11, 2014 By in Current Market Thoughts, hedge funds, Investment firms, Private equity Tags: , , , , , , Leave a comment

Late last year, Detroit revealed the results of an estimate by auction house Christies of the value of the city’s art held by the Detroit Institute of Art.  The figure was a range of $464 million – $867 million.  Let’s take the mid-point and call it $650 million.

Yesterday, I saw in the Wall Street Journal a new estimate by Artvest Partners and commissioned by the city that comes in with a range of $2.8 billion – $4.6 billion.  The mid-point here is $3.7 billion.

But wait!   …there’s more.  According to Artvest, if Detroit actually wanted to sell the artwork, it’s only worth $850 million – $1.8 billion.  Mid-point:  $1.3 billion.

OK, which is it—$650 million, $1.3 billion or $3.7 billion?

There is one subtlety.

–The $650 million is the (if you’re not selling) value of the art that the city has bought with its own tax money.  It does not include work donated to the DIA, where there may be strings attached that don’t allow the works to be sold.  (An aside:  there may be a further twist here.  The DIA has presumably either provided donors with appraisals of their gifts’ value, or validated appraisals donors have provided.  In either case, donors will have used these figures, which may be–shall we say, “optimistic”–to claim income tax deductions.  a potential mess that I have no desire to comment further on.)

–The Artvest figures, on the other hand, count everything as salable.

What caught my eye in the WSJ article is the gigantic difference between what the appraiser says the art collection is worth–$3.7 billion–and what it would fetch at auction–about a third of that amount.

What struck me is that this is a lot like the way, in my experience, that the market for illiquid “alternative” assets works.  So the Detroit case gives a rare glimpse into the inner workings of alternative asset valuation.

As in the Detroit case, there’s one value that investors hear about in reports from the management company, and based on which the manager charges his fees.  That, of course, is the $3.7 billion.

The other value is what investors would get if the alternative asset pool were to be liquidated today.  It’s what mutual fund investors would call net asset value, or NAV.  That’s the equivalent of the $1.3 billion.

Yes, part of the reason the actual sales value in the Detroit case is so far below the (I don’t know what to call it) “dream” value of the artwork is the possibility of donor litigation that would freeze assets for protracted periods.  On the other hand, any investor in emerging countries can face similar political difficulties.

Several factors do make the alternative investment case different from Detroit’s:

–in at least some alternative investment situations I’ve seen, the assets are so esoteric that there are few experts other than the asset managers themselves.  So the managers end up doing the asset value appraisals.  If so, I think they’ll tend to find it hard to arrive at a figure that’s not in the rarified air of Artvest’s $3.7 billion.

–the contracts between investors and managers often allow the latter to refuse redemption requests for an extended period, so actual NAV may be a moot point.

–if investors insist on liquidation, asset managers may be able to make a distribution in kind–meaning investors get their proportionate share of the actual assets, not cash.

Institutions will do almost anything to avoid this situation, since they’ll be forced to safeguard and value any assets they receive.  (Early in my career, when Guinness was an independent company, some one there had the crazy idea of paying a dividend in bottles of scotch instead of cash.  This would make portfolio managers like me responsible for valuing and storing the stuff, and presumably eventually selling it, on behalf of my clients.  What a disaster!)

–based on NAV, it’s not 2% of the assets per annum that moves from the investors’ pockets into the managers’.  It’s actually 6%!  Ouch.

As I’m confident you’ve worked out already, I’m not a fan of alternatives.  The risks are hard to get your arms around; information is scanty; and in my view most of the returns go to the managers.  Investors mostly get to dazzle their cocktail party friends with their daring; they lick their wounds in private.

My thoughts aside,for anyone wanting to get a peek under the covers of alternatives, watching the Detroit art case should provide an education.

 

 

 

 

 

Bain’s “A World Awash in Money” (II)

August 22, 2013 By in Current Market Thoughts, growth vs value, hedge funds, Portfolio management, Private equity, Strategy Tags: , , , , , , , Leave a comment

Let’s assume that Bain is correct that the world will be awash in capital over the next decade or so, and that this money will be coming both from investors in the developed world and–increasingly–from the emerging world as well.

I draw two conclusions from this (keeping in mind that Bain may, or may not, be correct):

1.  Interest rates won’t rise as much as the Wall Street consensus expects.  The Fed is saying that the normal rate for overnight loans in the US is 4%+.  This implies that 10-year Treasuries should yield at least 5%, probably more.  If Bain is correct, these figures are much too high  …and, therefore, the rise in bond yields following Fed hints that monetary tightening is on the horizon may have already achieved as much as half the total rise that tightening will bring.

2.  Consider the factors of production:

–capital

–labor

–land/materials/resources and

–knowledge (technology, entrepreneurship, craft skill).

Which of these will be in short supply relative to the others?   I.e., which will be the most valuable?

If Bain is correct, it won’t be capital.

The natural resources boom of the past decade has resulted in mining companies making massive investment in new capacity.  Shale oil and gas are beginning to provide new low-cost sources of energy.  So the shortage factor is probably not land etc.

There’s still massive amounts of unskilled labor in emerging economies.  There’s also significant unutilized labor in the US and EU.  So labor isn’t the key factor.

That leaves knowledge, either as technology, craft skill or entrepreneurship as the factor of production in short supply.

 

For investors, the main takeaways are that:

–the current monetary tightening cycle may not be as negative for bonds or stocks as the consensus fears

–like the Internet, ready availability of capital undermines the defensive position of large companies with significant manufacturing capabilities and established brand names.  Think:  Hewlett-Packard, Dell, Barnes and Noble, J C Penney.

There’s a second point to this list, as well.  In all of these cases, finding leaders with the right knowledge base to put the firms’ substantial assets to work has proved to be very difficult.  It may be that in an environment where capital is easy to come by, talented entrepreneurs have much better alternatives than masterminding turnarounds for financial buyers.  If so, the value investor tactic of buying shares in asset-rich companies and waiting for something good to happen may not retain its traditional allure.  So-called value traps will outnumber successful turnarounds by a lot.

institutions reacting to poor hedge fund/private equity returns

August 20, 2013 By in Current Market Thoughts, hedge funds, Private equity Tags: , , , , , , 3 Comments

A couple of days ago, the Dealbook section of the New York Times reported on a recent meeting of the Institutional Investors Roundtable in western Canada.

The purpose of the organization, founded in 2011, is to help large government-linked investment bodies, like sovereign wealth funds and managers of government employee pension plans, cooperate to solve common problems.

According to the NYT, the agenda of the latest meeting was hedge fund and private equity investments.  Although the proceedings are secret, it doesn’t take a genius to figure out what went on.

The institutions’ dilemma:  on the one hand, they want and need the diversification and the high-return investment opportunities that hedge funds and private equity promise.   On the other, despite their colorful brochures and persuasive presentations, many hedge fund/private equity ventures produce pretty awful returns.

There are two main reasons for this:

–some hedge fund/private equity operators are brilliant marketers and well-connected politically, but that’s it.  They’re not great investors.  It doesn’t help matters that academic research shows a significant number of them bend the truth in stating their qualifications, track records, assets under management…

–the hedge fund/private equity fees are so high that there’s little extra return left over for the institutions who supply the investment capital.

The IIR solution?

It’s to try to develop hedge fund/private equity projects among the members themselves, thereby cutting out the fees charged by third parties.  One institution cited in the NYT article says doing so adds 5 percentage points to the annual returns it received from such projects.  On a world where bonds yield next to nothing and where stocks may produce 6%-8% annual returns, a 5 percentage point pickup is enormous.

This movement is in its infancy.  Not every institution will be able to participate, either because of political pressure at home or lack of even minimal expertise.  But even that may change in time.

The most important thing to notice, I think, is the evolution away from traditional Wall Street practices that make the financiers–and no one else–rich.  I think that sovereign wealth funds, bot from China and the Middle East, will take leading roles in this development.

Bill Ackman, J C Penney (JCP)’s largest shareholder, is leaving the board. What does this mean?

August 14, 2013 By in Current Market Thoughts, Portfolio management, Private equity, Retail, Stock ideas Tags: , , , , , , , 3 Comments

the JCP board and its CEO search

Bill Ackman is the activist investor who initially targeted (no pun intended) JCP as a serial laggard that could be made to perform better.  Recently, he has argued with the rest of that company’s board–at first in private–about the pace of JCP’s search for a new CEO.  Ackman believes the search could/should be done in two months.  The rest of the board seems to be thinking in terms of nine.

Last week he made public a letter he wrote to the board, which he concluded with, “We can’t afford to wait.”

This week, after being criticized by many, he resigned from the JCP board.

Certainly. the spat between the board and its largest shareholder won’t speed the flow of CEO candidates knocking on JCP’s door.  On the other hand, it won’t deter very many, either, in my view.  What it does do is raise the price the new CEO can command.

The media have portrayed Mr. Ackman as a shallow, petulant Ivy-Leaguer having a mini-tantrum because he isn’t getting his way.  Entertaining and gossipy as that may sound, the media assessment is probably not right.  In fact, Mr. Ackman may prefer that people view the affair this way, because is suggests that everything else, save Mr. Ackman’s personality, is all right.

It isn’t.

what’s really going on

Two possibilities, one based on back-of-the envelope calculations, the other pure conjecture.  Both are based on the idea that the fact of the board disagreement has information in it–and that it’s not gossip column fare.

1.  a castle in the air

Let’s say the properties JCP controls are worth $5 billion.  That’s halfway between brokerage house estimates (which may ultimately come from Mr. Ackman) and the recently announced, but incomplete, Cushman and Wakefield assessment of $4.06 billion.

If we think the rental yield on these assets should be 7%, then the annual rental income from them should be $350 million.  That’s the amount a third-party would pay to do business on those properties.

How much does JCP pay?  I don’t know.  Certainly it’s substantially less than $350 million.  Let’s say JCP actually pays $50 million. This means that in a sense JCP real estate subsidizes the department store operations by the difference between what it could get by renting the properties to someone else vs. operating JCP stores on them.  According to what I’ve written so far, that subsidy is $300 million.  After income tax, that amounts to about $200 million.

Why is this important?

In 2010, the last year before Mr. Ackman brought in Ron Johnson to run the company, JCP made $378 million in net income.  If my numbers are anywhere near correct, over half JCP’s profits came from owning real estate.  In 2011, selling stuff lost money.

Strip away real estate gains over a long period and JCP’s retailing profits look very highly cyclical.  That makes sense, because JCP’s traditional market has been less affluent consumers, whose incomes are the most cyclical.  The company may suffer a lot during recession but makes up for that by making a relative killing as recovery gets into year three or four.

In other words, JCP should be cleaning up now.  Instead, it’s piling up enormous losses.  This spells potential trouble as/when the economic cycle turns down, and–if past form runs true–profits evaporate.

Maybe this is the source of Mr. Ackman’s sense of urgency.

2.  pure speculation

Maybe Mr. Ackman’s chief worry isn’t his projected timeline for JCP’s profits but the structure of the fund he put together to invest in the company.  He’s told reporters that his cost basis in JCP stock is $25.  But he may have financial leverage or options or other derivative instruments that make the risk/reward clock tick faster for his fund than for JCP itself.

Whatever the cause of Mr. Ackman’s behavior over the past few weeks, it’s almost certainly not simply pique.

Blackberry (BBRY)’s search for strategic alternatives

August 13, 2013 By in Current Market Thoughts, Industry Analysis, Private equity, Stock ideas, Technology Tags: , , , , , , , , , , , 1 Comment

a 6-K

Yesterday BBRY filed a 6-K (it’s a foreign–i.e., Canadian–company, hence it’s a 6-K, not an 8-K) with the SEC, which consists of the press release it issued at the same time.

In it, BBRY (BB for you Toronto Stock Exchange fans) says it’s setting up a committee to explore strategic alternatives, which the firm defines as “possible joint ventures, strategic partnerships or alliances, a sale of the Company or other possible transactions,”

BBRY also says the board member, Prem Watsa, CEO of BBRY’s largest shareholder, investment firm Fairfax Financial, has resigned from the board citing “potential conflicts” that may arise as the committee does its work.

What’s going on?

It seems to me that BBRY effectively hung a “For Sale” sign around its neck in March 2012–and has had no takers.  So the announcement appears to mean–and is being widely taken on Wall Street as meaning–that BBRY is getting ready to go private.  Mr. Watsa’s resignation from the board suggests his firm will want to be part of the private ownership group.

Why go private?  

Why can’t BBRY do what’s necessary while retaining its listing?  It’s all about financing.

1,  For one thing, it’s better to have no price than a low price.

BBRY may need radical surgery to survive.  Contrary to the picture presented in finance textbooks, Wall Streeters aren’t steely eyed rational thinkers.  The sight of blood and body parts on the operating table makes them woozy.  During restructuring, the stock price might decline–sharply, very sharply.  Professional short-sellers, whose job is to kick a fellow while he’s down, would certainly help push the price down.

The low price–let’s say $1 a share vs. about $11 now–has several bad consequences.

–It scares the wits out of potential sources of finance, either the junk bond market or commercial banks, who would take the same factual situation much more calmly if there were no plunging price chart.  This effectively cuts off liquidity, just as the firm needs it the most.

–The price could get low enough that the stock is delisted, another unnecessary black eye.

–Worst of all for shareholders, a stock that’s unattractive to acquirers at $11 may become irresistible at $2.  Shareholders might jump all over a takeover bid at $4–in effect “stealing” the patient right out of the recovery room.

2.  Look at DELL.  Silver Lake has lots of experience in turning around tech companies.  Its price?  …ownership of the company, i.e., the lion’s share of the profits from doing so.  That’s just the way it is.

3.  One of the ugly secrets of private equity is this:  sometimes, when the private equity owners sense the ship is sinking despite their best efforts, they make a large junk bond offering and pay out some or all of the proceeds as a dividend to themselves.  Their risk is lessened by the return of capital; that of the offering company is increased.  This maneuver would be impossible to accomplish with a publicly listed company.

4.  Yes, going private frees management from SEC-mandated financial disclosure and from the need to do extensive investor/press relations.  But I think this is a minor benefit in comparison with either #1, #2 or #3.