Private Equity Cracks

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IN THIS PUBLICATION:

• Private equity-backed public companies display poor profitability, high debt servicing costs, and premium valuations, but family offices don’t seem to be inclined to reduce their exposure.

• Don’t chase big tech after the significant re-rating and decoupling with 10Y yields in 1H.

• Energy continues to be the cheapest sector available to investors today.

Private Equity Cracks

We’re currently living in strange times.

We live in a world where private equity asset prices are trading at a premium to public ones. This is a weird set up if you consider that private equity assets should, and typically do, trade at a discount to public markets given (1) lower liquidity and (2) traditionally higher leverage. The latter matters significantly more in a world of higher interest rates.

Understanding what’s happening with private equity prices (and, to an extent, venture capital) is not that straightforward partially because private market investments are not marked-to-market continuously, as is the case in public markets. This gives them (private markets) the ability to obfuscate performance for a long period of time, which is again counter to the daily performance metrics supplied by public markets that anybody with a smartphone, anywhere in the world, can get access to at any moment in time.

But, for Verdad, that’s a hard pill to swallow, which is why they’ve recently crunched some numbers to give us an indicative idea of what’s happening behind the curtain. As always, all credit to them for their outstanding work:

• “We took a look at all PE/VC-owned public companies, or companies with public debt, that were 30%+ sponsor-owned, had IPOed since 2018, had a recognizable sponsor as the largest holder, and were headquartered in North America.”

• They rightfully flag that this subsegment, which totaled $760 billion of value (6.5% of total private equity AUM), is likely to reflect some of the best assets held by private equity given that those were the companies able to find their way through public markets.

The conclusions are, as expected, not painting a pretty picture.

• EBITDA Margins: Whilst revenue growth is higher, “we looked at both pro-forma EBITDA, which 50% of the companies in our sample reported, and at GAAP EBITDA. We see below that PE-backed companies in our sample had significantly lower EBITDA margins than the S&P 500, especially on a GAAP basis, and have seen significant margin compression over the past few years. GAAP EBITDA is, perhaps unsurprisingly, much lower than adjusted EBITDA.”

• Leverage Ratios and Interest Costs: “These companies have a median leverage of 4.9x, which is roughly the ratio of the average B-rated company. However, this includes many overcapitalized VC-backed companies, which are difficult to parse out from the private equity LBOs. When we look at only those with net debt, the median leverage increases to 8.8x, which would put the median LBO well into CCC credit rating (for context, the median leverage for the S&P 500 is 1.7x).”

• “The sample of companies we looked at is nearly unprofitable on an EBITDA basis, mostly cash flow negative, and extraordinarily leveraged (mostly with floating-rate debt that is now costing nearly 12%). These companies trade at a dramatic premium to public markets on a GAAP basis [33.4x GAAP EBITDA vs 20.7x for the Russell 2000 Growth and 13.6x for the S&P 500], only reaching comparability after massive amounts of pro-forma adjustments [mostly stock-based compensation, bringing the multiple down to 22.4x pro/forma EBITDA].

• And, again, these are the companies that most likely reflect the better outcomes in private equity. The market and SPAC boom of 2021 presented a window for private equity and venture capital firms to take companies public, and private investors took public what they thought they could. Presumably, what remains in the portfolios was what could not be taken public.”

According to Goldman, family offices across the globe currently have 26% of AUM allocated to private equity.

What’s more interesting (read: worrying) is that few plan to reduce allocation to private equity over the next 12 months.

Time to call your private banker?

Don’t Chase Big Tech

We’ve all heard about stock market concentration this year. If you exclude the 7 largest companies in the S&P 500, the market was up 3.8% in the first half of the year (instead of 16%).

• In a neat series of charts below, courtesy of JP Morgan, we can clearly see how the excitement around the AI narrative (an early 2023 story) plus the flight to safety post-SVB collapse (March 2023) has driven multiples (left chart) of the largest companies higher, not their earnings (bottom right). This means that, for these valuations to be sustainable, we’ll need to see earnings grow pretty significantly pretty soon (i.e. the hurdle for big tech to continue outperforming has moved significantly higher since the end of 2022).

• That obviously only matters if you believe that the market still cares about fundamentals… (Cem Karsan and Roger just did an outstanding pod on this that you should check out.)

Chasing big tech at these levels looks a bit too risky for me, especially as this chart gets scarier and scarier (the US 10Y yield is trading at levels last seen during the SVB collapse…):

Keep an Eye on Europe

• The SX5E (Euro Stoxx 50) continues to trade rangebound.

• But whilst the US economy is doing well, Europe is not… I’ve argued for a couple of months that the rally in Europe has gone way too far (Keinemusik’s tour around Europe and late-night shenanigans at Moni are not enough to drive the whole continent’s economic growth higher).

• This matters quite a bit as Europe doesn’t have the tech leadership the US has (no AI boost), the ECB is behind on the tightening cycle, energysupply worries are likely to pick up again over the next month or two, the Rhine (key commodities transport channel in Europe) water levels are drying up well ahead of historical norms, and geopolitical risks continue to escalate.

• As highlighted recently by Bobby Vedral: “(1) For sure Putin will use this [Prigozhin Rebellion] as a pretext to purge the Army leadership. Prigozhin’s advance to Moscow was far too easy. That in itself could trigger further rebellion. (2) Putin’s previous strategy to play for time, waiting for Western support to fade, now looks risky. Makes both peace negotiations or “going tonto” (tactical nuclear?) more likely. The tails have just fattened.”

2Q Earnings Season

• Consensus expects revenues to decline by 0.4% versus Q2 2022 (4.5% decline in real terms when adjusted for inflation), and earnings by 6.5% (10.6% decline in real terms) – this is unusual for periods outside of a recession.

• My 2 cents: this is setting the stage for us to see revenue and earnings beats across the board, yet again.

What the Bears Will Say

Mike Wilson from Morgan Stanley has been a persistent bear throughout the year as he believes EPS will come in below consensus estimates in the second half. His latest thoughts, according to Market Ear, are:

“1. The liquidity picture is starting to deteriorate due to record levels of Treasury issuance and QT. Morgan Stanley estimates bank reserves will contract by $500-800B over the next 6 months, which is likely to have a negative impact on equity valuations.

2. Fiscal support has been much higher over the past 12 months than most investors appreciate, based on our conversations. This is expected to peak and reverse next month and could amount to a 6ppt headwind to nominal GDP over the next 12 months.

3. The technical picture remains poor with recent breadth improvement failing yet again.“

Where to Look

Goldman has put forward the idea of the catch-up trade for 2H, which we covered last month:

• “Goldman ran a study on the 12-month implication of such market breadth: “Following 9 other episodes of sharply narrowing breadth since 1980, the S&P 500 typically traded sideways during subsequent months as rotations continued within the market. In addition to below-average returns, drawdowns have also been larger than average in these experiences. Eventually, however, a “catch up” has been most common, with S&P 500 valuations and prices increasing alongside a reversal of intra-market momentum”.

• Calling for a catch-up opportunity for the rest of the market after a short period of sub-par returns is not unreasonable if you think that most of the market is, in fact, cheaper than history – the bottom 450 stocks in the S&P 500 currently trade at 15x forward PE (vs 16.8x long term average for the whole index).”

Whilst there’s probably some upside on the table still, the reality is that most of the money that could have been made at the index level has already been made. That’s also consistent with price action in past inflationary cycles.

But unremarkable index performance doesn’t necessarily mean that there is no alpha available in the market – quite the contrary. Investment opportunities are now to be found in the segments of the market that have lagged behind the performance of big tech in 1H. Some areas that are worth looking at:

• In terms of style, you might want to consider reducing growth exposure and moving into more value names.

• Value names, which traditionally trade cheaper than growth names and tend to have better visibility into cash flow generation, should also help you on the downside in case the boogeyman of the recession finally materializes.

• JPM estimates that there are still $800 billion of excess savings in the US, and that’s likely to support consumer demand through the end of the year – but given how everyone is looking at the same data sets, I’d argue that you want to position for that before the end of the year as the market moves well ahead of the economy.

• Sector-wise, the cheapest opportunities continue to be available in the energy sector. Recessions don’t tend to be good for commodities, but given the price action year-to-date, I think recession risks are very much priced into the sector (if you want a refresher on the base case for oil, check out last month’s Markets Update).

• Outside of the US, Japan continues to offer interesting long-term opportunities. As many of you know, since February of this year we’ve been bullish Japan (we recently updated our Research subscribers on this, and we’ll be following up on the theme next week as well). A summary of the bull thesis has been neatly laid out by JPM’s Michael Cembalest:

1. “Japanese equities trade at 25%-30% P/E discount to US, as they have since 2016

2. Record increase in stock buybacks driven by corporate governance reforms (i.e., Sony spinoff/buyback)

3. Governance reforms: [a] ~50% of companies trade below book value and must outline a plan to maximize shareholder value and comply with shareholder, liquidity and outside director reforms; [b] 10%-20% of companies do not comply with cross-holding and free float criteria and must remedy or face delisting

4. Half of Japanese companies have positive net cash positions vs <20% in the US/Europe

5. Very low positioning in Japanese equities by non-Japanese investors

6. A recent surge in non-Japanese LBO activity in Japan, which is extremely rare (discussed earlier)

7. Lower wage pressures than US/Europe, COVID supply chain pressures easing

8. Earnings expected to be flat vs contractions in the US and Europe

9. The lowest real effective exchange rate in Japan in 50 years according to CEIC; the Yen has also depreciated by 30% vs the Chinese RMB, which is relevant since Japan now exports more to China than to the US.”

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