Private Equity Drag

I’m lucky to count among my friends Charlie Michaels, owner of hedge fund company Sierra Global and portfolio manager of the Sierra Europe Fund. Charlie is among the few hedge fund managers sitting on a gain so far this year.

According to the HFRI Fund Weighted Composite Index managed by Hedge Fund Research, Inc. in Chicago, the average hedge fund dropped 5.4% last month and is down 15.5% so far this year. The industry has been losing for five months in a row, which is the longest down streak since the index began in 1990. You can read more about recent hedge fund troubles at Bloomberg.

Charlie and his team at Sierra Global, meanwhile, gained 0.2% in September, 3.0% last month, and are up 8.6% so far this year. The only year the Sierra Europe Fund ended down was 2002, when it lost 12.3%. The FTSE 100 lost 25% that year and the DAX 42%, so even Sierra’s loss that year can be chalked up as a relative victory. All of which is to say that it’s worth paying attention to Charlie when it comes to stocks.

That’s why I’ve concluded every edition of The Neatest Little Guide to Stock Market Investing with a comment from him. He wrote for the 2008 edition:

The stock market is being propped up by the hundreds of billions of dollars allocated to private equity funds. These funds are levering their capital and buying companies right and left. There will come a time when these funds become net sellers (the day of reckoning) as their performance fees are based on realized profits. Hence the private equity prop will turn into a private equity drag. It is vital to invest in high quality companies with strong business franchises that are most likely to be resilient in the next bear market. Timing is important in most walks of life including investing. Hence, I advocate being patient and buying shares when valuations are attractive (low/cheap) so that when price earnings multiples compress, the securities you have bought will be resilient and hold up.

It looks like Charlie got it right again. He forwarded to me the following bullet point from a Keefe, Bruyette & Woods summary note sent to clients last Friday:

Forced Selling Risk — WSJ reports institutional and retail investors in private equity may soon be forced to follow through with legal commitments to provide additional capital, which could result in forced asset sales. Private equity generally entails a ~10-year investment and those who do not put up all capital at once are often later obligated to provide funding as needed. On its earnings call on Thursday, Blackstone stressed that investors have a legal obligation to meet capital calls, emphasizing they can otherwise lose 50% of their existing investments.

Doug Kass wrote in an Oct. 30 article at that private equity is the next shoe to drop:

In essence, like their hedge fund brethren (whose dirty little secret was that they were levered capital pools), private equity firms took uncommon risk (debt and leverage) in producing common returns. Stated simply, the early (historical) successes seen in private equity returns were an illusion. The foundations of private equity deals, similar to those of securitizations (in mortgages and elsewhere), were cracking as the money poured in under the appearance of good investment performance.

While the recession continues to emerge and the credit markets remain seized up, years of positive returns (both real and make-believe) are now going up in smoke. (Watch for some major university endowments, whose returns were buoyed by impressive private equity returns, to report large losses in the asset class in their current fiscal year.)

Like post-2005 vintage mortgage lending, most private equity deals done over the last two and a half years (estimated at over $900 billion) are now worthless (as are some of the early vintages). Unfortunately, those unrealized losses have not even been reflected in the marks of private equity investors (including many hedge funds) around the world, who are likely to see their own black swan event in the near future.

Nonetheless, it makes sense to look for value in this market. Bad news will not last forever. As usual, I’ll give the last word to Charlie, who wrote in his Nov. 4 letter to shareholders:

We believe it will take some time before corporate and economic fundamentals begin to improve. However, the “perfect storm” market conditions experienced in October have likely brought down many companies’ share prices to attractive levels. By traditional measures of P/E, P/Book, P/Sales, shares look attractively valued. It stands to reason the panic that ensued as the world’s financial markets neared a complete meltdown have likely knocked equity valuations down considerably. Hence, the likelihood of generating positive returns from long investments has increased considerably.

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