Taking Stock 4 May 2023
WHEN there is any rapid change in any market, there are sequential responses that over the decades repeat themselves.
We have all again watched how a rapid rise in interest rates causes a sharp fall in prices and liquidity in the property market.
We all watch as dreadful market performances force pension funds to take much bigger risks in their quest to hold onto their mandates.
We are all about to see how bumbling political fiscal behaviour leads to a change in the value of currencies.
And we can now be alert to the certainty that unnatural falls in equity prices and equity market liquidity usually results in opportunistic takeovers, effectively stealing from under-informed shareholders. This is especially true when a company has no single shareholder with a large holding. It finds itself unable to rustle up a defence mechanism overnight.
A company whose well-crafted long-term assets have a replacement value implying the current share price is absurdly low must be a real target for any opportunist whose funding is long term and whose target is value, rather than cash. Such opportunists can legally steal in times of stress.
We must look at these threats as they are hatching.
Private equity firms may be the threat. They are beneficiaries of long-term money, provided by pension funds whose incoming cash is reliable, meaning there is no pressure on cash returns from the PE investor. Other people's money is not able to be withdrawn.
Furthermore, if a PE fund buys out a listed company, the visible trading ends, and the quarterly or annual mark-to-market disciplines disappear. You cannot ''mark to market'' if there is no transparent market.
Take this example to illustrate my point.
KiwiSaver fund Gourmless, fearful of losing mandates because of miserable performance from its portfolio of listed securities, allocates $500 million to private equity fund, Be Patient.
A listed company named Undervalued has a long-term, skilfully chosen, asset base whose value will be obvious in five years, but whose ability to shed dividends now is low. As a result, Undervalued has a listed share price of $1.00, but in five years would be paying sustainable dividends of 25 cents, implying a future share price of, say $4.00. Its asset ''valuation'' might be a (meaningless) $3.00 now.
So PE fund Be Patient bids to buy out Undervalued at $2.00. The impatient or uninformed shareholders grab the offer, comparing it to the daily share trading at $1.00.
Undervalued is delisted. The PE fund then has closed off the visibility of the company.
After a year, Be Patient gets Undervalued assessed by its friendly valuer who declares that the assets of Undervalued are really worth $3.50 per share. Be Patient then tells Gourmless that it has so cleverly bought Undervalued that it has had a 75% return on the investment and that as a result its fund to which Gourmless placed $500m of other people's money has had a 50% return.
Gourmless then tells its Kiwisaver clients that, thanks to its genius, their shareholders have had a fantastic (theoretical, non-cash) return.
Who has lost in this transaction?
Of course the answer is that Undervalued's original shareholders have lost because of two reasons:
1) They were impatient and accepted a sub-par takeover offer;
2) The directors of Undervalued had failed to inform their shareholders of the good returns that were imminent.
Gourmless' dopey governors would have achieved much better long-term results by buying and holding Undervalued shares but they put the fund owners' interests first by chasing short-term, mandate-winning returns by allocating money to Private Equity businesses, and agreeing to pay the extreme PE fees for performing a transaction they could easily have done without external fees.
There is little room for debate on this. We will all soon be observing troubled pension funds telling us that they are allocating more money to invisible unlisted assets. The pension funds deserve no respect for such self-serving behaviour.
Private equity quoted returns cause distortions, veiling the truth exploiting the (meaningless) theoretical valuations from friendly valuers and stealing their huge fees and bonuses (often 20%) of such ''wins'' as they would collect when buying the guileless Undervalued.
One of my favourite companies, Infratil, plays this game with its extraordinary, vulgar bonuses based on its shareholding in the Canberra Data Centre. CDC's market value is established by a guess but Infratil has been able to extract hundreds of millions in bonuses based on that guess.
Crassly, some argue that if Infratil was not allowed to pay itself bonuses on valuations, but could pay itself bonuses only on realised gains, then, they argue, Infratil would prioritise its own bonuses by selling Canberra Data Centre without regard to its growing value, rather than allow it to accrue value, albeit at an unmeasurable and uncertain annual amount.
The organisers then say this example proves that the alignment of private equity and retail investors only occurs if these ludicrous bonuses from valuation gains are paid in cash (from borrowings) every year, ensuring the fund manager does not prioritise its bonuses.
What an abomination to posit such an argument! (I argue that if bonuses have to be paid at all, then as is the case with a capital gains tax, payments must be made only on realized gains)
Private equity lives on the funds provided by wealth funds, pension funds and high wealth individuals. Usually its owners also provide personal capital.
Its annual fees are extreme.
It can easily leverage the money it raises by subordinating contributor cash behind a prior security, often given to banks for loans that might double the investor contributions, enabling Private Equity firms to target big, expensive ideas. Such lending is what helped destroy Credit Suisse.
If the ideas backfire, the banks seek to be repaid before the failure destroys the fund, stripping the value from retail investors, who will always be the last in the repayment queue.
Crucially, the pension fund will then argue that the loss was not the fault of the pension fund.
Private equity funds can tackle long-term deals, whereas most banks will provide only short-term lending. Pension funds of any value do not need Private Equity to make long-term decisions.
All of these thoughts are relevant today because the world's markets now in many areas quote daily trading prices that are a falling percentage of the long-term value of the assets employed.
As an example, Ryman Healthcare in New Zealand might have assets which are genuinely worth $10 per share but its shares might trade at $5.30, because of various reasons:
1) The dividends have been cancelled while debt levels are high;
2) The banks will not lend at fixed rates for terms that match the duration of the asset;
3) The media criticise the sector, somewhat unknowingly;
4) The institutional shareholders crave short-term returns (to keep their mandates);
5) Various goofs, including our public sector-trained Retirement Commissioner, attract headlines by blowing up the relevance of minor, rare blemishes in the industry. These people imply there is something astray in a sector which would have a higher user-satisfaction rating than almost any other sector in society. I suspect their arguments are more attention-seeking than problem-solving.
Ryman, and its sector, is enduring a period of being out of favour. Unless the goofs destroy the sector, Ryman will in the coming years be seen as having been unfairly disrespected and undervalued in 2023.
Let us hope no PE fund scores hundreds of millions of bonuses at investors' expense when the company is again respected and shown to be adding value while it generates wealth.
As night follows day, when interest rates rise, stupid short-term stresses prevail and sad consequences follow.
Interest rates do not rise inexorably forever.
A company's best prevention method to ward off PE funds is to communicate so well that when exploitative takeover offers are made, the shareholders will have the knowledge and patience to decline to be a victim of stressed times.
Board directors and chief executives take note: it is your job to ensure your shareholders are properly and fully informed and thus will be protected.
In my career, I have watched various strategies, used well, to defer exploitative takeovers.
I have a mission to share what I have learned, if only to reduce the number of rorts imposed on retail shareholders.
(20min delay)