The Dividend Cafe - The Landscape for Private Markets

Episode Date: April 14, 2022

In this market-shortened week I thought a shorter Dividend Cafe may be appropriate, especially as we prepare for a long weekend and the Easter holiday. More on that below … And not only do I think I controlled the length of this week’s Dividend Cafe (within reason), I also took advantage of the week to dive into a topic that is almost entirely avoided by the media and investing public. I can’t really explain why we mostly ignore private equity and private credit when we discuss financial markets. I understand public stock markets have a certain sensationalism to them, not to mention clear pricing visibility that facilitates a lot of noise. But the private markets are just as much the real economy as public markets, and if the heart of free enterprise is where there is human action, I assure you private markets are deep into the capture of human activity (for good or for bad). But it is not enough to “talk” about private equity and private debt as if they are either “good” or “bad” investments. There is a complexity here that requires a bit of unpacking, and the unpacking of complexity is the business of the Dividend Cafe. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Well, hello and welcome to a special Dividend Cafe. It's a little weird recording on a Thursday, but Friday, April 15th, this week is good this year is Good Friday and we're going into the Easter weekend and the markets are closed tomorrow Friday the 15th and our offices are all closed and so we're doing the Dividend Cafe today and I decided to kind of take advantage of a special week to address a very special topic. You know, I kind of have a pretty set theme that I like to use the Dividend Cafe for. Various behavioral principles in investing, a lot of macroeconomic coverage that centers around monetary policy. The Dividend Cafe has its sort of favorite topics to cover. But one thing that I hope the Dividend Cafe does, and it's certainly my intent, and to the extent it

doesn't do it consistently or perfectly, you know, that's just because we're constantly striving to improve. But the goal is to take things that I think are generally kind of complicated or have the potential to be complicated and simplify them and break it down in a way that for some people they can sort of extract takeaways and understandings about more complicated investing ideas through the Dividend Cafe than they would otherwise. And the subject of today's Dividend Cafe is definitely one of those things. Private market investments. We hear the term private equity a lot and lately we've heard more about private debt or private credit. But both the equity and debt side put together make up what we call private markets.

And it's become a just massive part of capital markets in our country and globally for that matter. And it's become, therefore, as it's increased in its presence in financial markets, it's become a much larger option for the investing public. And not only do I believe private markets represent an entire new avenue for people who are in financial markets, in commerce, business operators, looking at various liquidity partners and strategic partners, but then even those on the outside, not connected to a given business, now have a greater access to be invested in that business in one way or another because of private equity. And particularly since the financial crisis, private debt as well.

And so I don't want to go into the weeds of a lot of those things. If I wanted to do kind of like a six part series on this, I could really unpack some of the different ingredients, the distinctions between direct lending, middle markets, what some of the private credit options are. And then on the private equity side, what a lot of the different components are when one is making an investment in a private company early, what venture capital later rounds, you know, there's almost a sort of tutorial around corporate finance that could be done here. And it's most certainly one of my favorite topics.

And we manage the capital of a lot of business owners and entrepreneurs who are themselves engaged in in needing expertise around corporate finance and so it's a subject near and dear to our hearts but my purposes here in the Dividend Cafe are how the investing public can extract value out of any investment opportunity in private markets have become a very large opportunity set. And yet there's a lot of chatter about it right now and potentially a kind of resurgence of risks. And I think it's important for us to kind of address some key principles around this today. First and foremost, just to kind of get the obvious out of the way, why would people, First and foremost, just to kind of get the obvious out of the way, why would people,

the bond market is very liquid, is very transparent. So people want to just invest in debt and get a fixed income instrument that pays them a set coupon and then offers them a return of principal at a maturity date. There's a very large bond market across treasury bonds, municipal bonds, mortgage bonds, corporate bonds. So why go into private debt? And then, of course, on the equity side, there's a gigantic public equity market. There is very large capitalization companies in the Dow and the S&P 500. There are smaller cap companies in the NASDAQ and even smaller still in the Russell 2000. There are global equity markets. So there is a kind of instant liquidity in both public bond and public stock markets. Why go into private equity or private debt at all?

And the answer is the very thing people are bringing up as a negative. There is an illiquidity associated with the privacy of debt and equity markets that I'm referring to, and that illiquidity is often an advantage. It provides a certain premium in return, but there's a give and take. my own book, there's no free lunch. You have to give up liquidity when you go into private markets, but what you gain is the illiquidity premium, the potential benefit of a premium of return by nature of the illiquidity. So right away, you eliminate a significant amount of the investing public who just simply either can't afford or can't tolerate or is not comfortable with the dynamic of forfeited liquidity. OK, but to the extent one is investing capital that they do not need to access in either the near future or potentially ever, or certainly not day to day, private markets now provide an opportunity set. And that illiquidity has largely been defined traditionally as the premium return that one expects to get because of forfeiting liquidity.

And yet I will add that I truly believe, first of all, there's a sort of known arbitrage thinking, a kind of mechanical idea that in theory private markets might be buying companies at eight times earnings that are illiquid and then putting them into public markets at 15 times earnings because they then are liquid. So there's this embedded arbitrage and those numbers have changed a lot and what they may average and whatnot is kind of immaterial. But people are certainly pursuing, in theory, in that illiquidity premium, some sort of mechanical edge. I get that. But I would argue that there's a very large behavioral edge, simply that the number one worst thing that investors ever do is buy when they shouldn't buy and sell when they shouldn't sell. And it's

very hard to sell what you can't sell. And so the analogy I use was the state of the restaurant industry right as COVID was breaking out. Anyone who was looking to sell their publicly traded food, beverage, hospitality companies was selling at just fire sale prices that almost immediately corrected when some degree of rationality and normalcy came back. And yet, on the private side, those companies, if they had been able to be sold, would have been worth zero or something very, very low. Most of these establishments were shut down. And yet, thank God, people couldn't sell, you know, and hopefully there was some value recapture as life normalized. So, you know, you get varying degrees of behavioral modification when you simply can't poorly modify behavior. in mechanics of arbitrage or in just the expected rate of return or the behavioral advantages.

This is sort of why more sophisticated investors might pursue some allocation into private and illiquid markets. And it's why it's become a big part of my own portfolio and a big part of the portfolios that we manage at the Bonson Group on behalf of clients. And yet there's some discussion right now around froth in the space. And I think you can talk about the S&P 500 with froth or not froth, even though there are some companies in the market index at any given time that may not have the same froth as others. And yet it still is a universal discussion because a lot of people own the market universally. When you buy an index, you are eliminating yourself from the discussion of where there's froth in valuation versus where there's not. yourself from the discussion of where there's froth in valuation versus where there's not.

You're just sort of catching all of it in what we call market beta together. But I don't think there's as much of a thing as private equity beta. It would be harder to capture. It would be harder to invest in. You don't have this readily accessible, let alone liquid, let alone, you know, massively owned index of private equity beta, like the very definition of the S&P 500 is. And so when I look at some of the characteristics we're talking about private markets, there was $1.1 trillion of deals done last year globally in buyouts and private equity transactions. And the year before, it had been about $800 billion. Excuse me, it had been about $600 billion. The all-time record had been about $800 billion back in 2006.

had been about $800 billion back in 2006. And really from about post-crisis to around 2019, it had been somewhere between $200 billion, $300 billion a year in the United States. I think that the notion that there's a larger volume of transaction is noteworthy, but I don't believe it's in and of itself this screaming indicator of a problem. First of all, let's remember, $1 trillion now compared to $800 billion 16 years ago is not the same thing because you're looking at two different numerators, but you're ignoring the denominators that are drastically different, either comparing the ratio of private markets to the size of public markets. Well, the public markets are double, triple,

quadruple the size. In 2006, they'd be about quadruple the size, certainly over triple. And from 2006, the overall economy is much larger. So there's a sort of relativity to it that is being ignored when you just look at the dollar volume. But also, I'm not sure that the dollar volume itself speaks to something problematic. You have to remember that the size of the private equity managers, the largest companies that do a lot of deal flow, they're three, four, five times as big. And in theory, their opportunity sets for a lot larger companies than there previously would have

been. And so in and of itself, you know, does a high volume of transactions and a high volume of dollars in the transactions potentially mean something concerning, bubbly, irrational, frothy, potentially. But when you look under the hood, ultimately deals have to be evaluated by the specifics of the deals, the strategic advantages, the synergies created, the potential for unlocked value, and of course, the economic fundamentals. And I'm not really sure that when we say, well, deals were being done at 10 times, now they'll be done at 14 times, that anyone wants to apply that logic to private equity if they're not willing to apply it to real estate or to public equity markets. In other words, valuations are higher in private equity now because valuations are higher in all risk assets now.

The question is, are they disproportionately higher? And I don't see any evidence of that. I think that valuations being higher makes me more discriminating, but it makes me more discriminating in real estate, debt, public equity, emerging markets, and in private markets. public equity, emerging markets, and in private markets. Discrimination is an important and elevated characteristic of investing whenever valuations are higher, not limited into the private space. I also would add there's a lot more operators now, a lot more managers in private markets.

Therefore, there's a lot more bad ones. And maybe there's a lot of good ones that are just unproven. But I'm not willing to go be like a guinea pig with my money or with my clients money in some of those things. So I'm gonna have to avoid certain private equity capabilities that might have really good talent embedded, but is just not reputationally or institutionally or structurally proven yet. So there is an advantage to track record. It is not that past performance predicts future results, because we know it does not. But there is a risk mitigation around a culture, around a track record, in particular a track record that has been through various credit cycles, economic cycles, interest rate cycles, etc. There's a history there versus some very bright, sharp person, but maybe has never invested in different types of economic landscapes.

So our chosen path is to favor more established and oftentimes brand name operators, recognizing that there is going to be certain really huge idiosyncratic opportunities that we're consciously avoiding to avoid some of the idiosyncratic risks that we're just uncomfortable with. In the private market world, debt and equity, I would particularly favor leverage discipline, purchase discipline, an exit process. How does one seek to monetize the investments? And I would encourage a process around understanding these things that requires an understanding of incentives. What are the incentives of the companies, the operators, the managers, the buyers, the sellers? Because then you can get to an understanding as to why one's selling, what they're looking to do

with the capital, what they stand to gain in the future, if they do well, which of course impacts if you do well. And I don't believe there's enough discrimination going on in understanding incentives. Now, by the way, I want to understand the incentives of the C-suite of public companies, too. It's one of the travesties of American finance that there have been so many C-suite operators whose incentives are wrong, that they are not engaged. They don't have enough skin in the game. They don't hurt enough when things don't go well. I want public equity operators to have buy-in, and I most certainly want that out of private equity operators. And I think we have a way in our due diligence of assessing who has that right skin in the game and the right incentive structure to align us.

Then one still has to execute, one still has to make good decisions, but the incentives have to be the sine qua non of the whole process. So rather than focus on deal flow and dollar volumes and charts that look like things have moved up a lot, valuations always have to be understood relative to all asset markets. And incentives have to be qualitatively understood to make good decisions. And this is as true in private markets as anything else. So I hope that's a bit helpful. I wanted to keep this short on purpose. I know you have a long weekend in front of you.

This could end up getting very wonky if I'm not careful, but I think this is a nice basic introduction to some of the things we wanted to share about private equity, private debt investing. Read DividendCafe.com. I love our chart of the week today, and I love adjusting a new topic, and I certainly welcome your questions and feedback that we'll be happy to address in next week's DC Today if you are so inclined to send me questions. With that said, have a wonderful Easter weekend. God bless, and thank you for listening to The Dividend Cafe. tower advisors LLC, a registered investment advisor with the SEC. Securities are offered through high tower securities LLC advisory services are offered through high tower advisors LLC.

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