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MR. MICHAEL CEMBALEST: Good afternoon everybody. This is Michael Cembalest with the last Eye on the Market Podcast for 2023. This is our biennial, which means twice a year, alternative investments review. And this one’s called It’s Mostly a Paper Moon. Anybody that’s around my age would remember The Paper Moon movie. And The Paper Moon refers to something that looks very real but may be partially an illusion.
So in this piece that you can read that was sent out today, we have information on private equity, venture capital, hedge funds, real estate, infrastructure, and private credit.
I’m going to go through just a couple of the findings on this podcast but obviously if you’re interested in any of those things in detail you should take a look at the piece that we sent out. And let’s see.
Let’s take a look at what we’ve got here. So the first thing that jumped out at me was — and I work with someone named Steve Kaplan at the University of Chicago who aggregates a lot of private equity performance data, the last time we looked at this a couple of years ago, the recent private equity vintages were barely outperforming the public equity markets.
And we have some charts here that show that whether you’re looking at the average manager or the median manager, there’s been a noticeable improvement in performance in those 2016, 2017, 2018 vintage years of private equity compared to the public markets. And here we’re showing a ratio of private equity to public equity outperformance or underperformance.
And so what we get into in the piece is a look at how did this happen. And obviously the first place that we stopped here was to look at a surge in private equity activity that took place and exit activity that took place in late 2020, early 2021.
So part of the reason for improve private equity outperformance was a lot of companies got sold at very high valuations. And I think all private equity investors owe a giant thank you note to the IPO markets and in particular SPAC investors because a lot of companies got sold at inflated valuations, didn’t do so well after they went public. And for those of you that read the IPO paper that we sent out in July of this year, that’s when we analyzed the aftershock of those companies going public.
But as it relates to private equity, a significant part of the improvement in performance versus public markets came from all the monetary and fiscal stimulus which pushed up risk appetite and multiples and allowed private equity firms to sell a lot of the companies they had invested in, both good and bad ones.
My biggest question is why some of the managers didn’t even sell more of the companies that they held given the conditions that prevailed at the time.
But the thing that struck me was, even after looking at the impact of being able to sell a lot of companies at good prices, a lot of the value in these private equity returns that people are seeing are still on paper. And we have this chart in here and a table also in the document that explains what I mean by that which is if you look at, for example, the 2017 or ‘16 vintage years, and you look at the percentage of the total NAV that’s a function of distributions and a separately a function of the remaining value of where positions are marked, both of those vintage years, more than 50% of the total value in the NAV is still a function of remaining positions.
So in other words, where those positions get marked and where those positions are ultimately sold in a world of higher interest rates are going to have a big impact on the ultimate performance and outperformance of those private equity vintage years.
And that’s what I meant by the paper moon thing which is you know if you invest in a 2016 private equity fund you might be tempted to think that 7 years later that the vast majority of your total economic value would already have been monetized but that’s not necessarily the case.
Now obviously these are average managers and there are wide exceptions on either side of this. But this is pretty good industry data for the median manager.
So now. Obviously there are some questions to ask about where positions are both marked and where they’re ultimately going to be sold. I think if you look at average LBO purchase price multiples from 2004 to 2018, they are kind of around 8, rather than 10 to 12 which is where they were in recent years. So there are some legitimate questions to ask about where those private equity vintage years, those performance numbers, are going to be after the remaining positions are liquidated.
I think Bain had an estimate that there’s close to $3 trillion of private equity companies that still have to be monetized in the next 3 to 5 years. That’s a lot of companies.
And we’re starting to see additional signs of distress of some of these private equity firms. One place to look is what’s happening in the loan market. And Moody’s estimates that around more than half of all B-minus rated loan borrowers won’t be generating enough cash to cover both capital spending and debt service by the end of the year. We’re starting to see actual cash flow stress taking place in the loan market due to rising interest rates.
We’re also seeing a big increase in amend and extend activity in the loan markets which basically refers to preemptive extensions and amendments and restructurings and things like that. It’s running at its fastest pace since 2009. So while the NAV marks in private equity are adjusting slowly, underneath the hood we can start to see — we are already seeing some turbulence there.
Similar story in venture capital. So in venture capital a couple of years ago, the 2016 and 2017 vintage years were just flat to public markets or even below. Now those valuations look better than public markets and again there as a surge in monetizations in 2020 and also in particular in 2021, particularly for VC because that’s when a lot of the SPAC issuance for healthcare and biotech and technology got done.
As you can see here, I mean this is kind of remarkable to go from let’s say $150 billion’s worth of venture capital exit activity in 2018 to $800 billion’s worth by 2021. A lot of companies got sold and a lot of them didn’t do too well.
But despite that surge in monetization, in the venture capital industry, venture capital investors on average are even more exposed to ongoing market conditions that private equity investors. We have a chart in here that shows, let’s go back to that 2016 vintage years. The average private equity investor for that vintage year as 50% of their total NAV subject to market conditions.
For venture capital, in that same vintage year, it’s over 80%. So I did not expect to see these kind of results. But for the venture capital industry, the amount of un-monetized positions for a lot of these vintage years are still really high. It doesn’t mean that the outperformance numbers are going to crater because presumably there’s some connection between both public and private markets.
But I just thought it was important for people to understand that if you’ve been investing in private equity and in particular venture over the last decade a lot of your IRR or multiple of invested capital that you ultimately earn is still on the table and subject to market conditions.
We have some charts in here that show that some of those market conditions for venture are changing. A huge, a practically a doubling of the median time between venture rounds whether it’s from the seed round to A, or A to B, or B to C, an increase in startups shutting down due to bankruptcy and liquidations.
And then we have a chart in here that’s going to take a couple of minutes for you to digest but I think it’s interesting to look at. It looks at, for example, in the Series C rounds, just from 2022 to 2023, what percentage of new funding rounds were down rounds, in other words the valuation applied to the company was down, so just over the last year that went from only 5 or 6% of down rounds for C and almost 20% now.
And of the down rounds, the decline in post-money valuations went from 30% to 50%. So to put it in an English sentence, almost 20% of funding rounds for VC in 2023 were down rounds with an average valuation decline of 50%. So conditions are obviously changing in the VC industry.
Real quick on hedge funds. We’ve done this exercise a couple of times before. And I was kind of surprised about how well the numbers turned out given the narrative that you read about in the financial press.
We took two different hedge fund databases. We randomly created a portfolio, diversified portfolios, with 20 hedge funds each. And we just looked at the annualized excess returns over T-bills and then volatility of returns. We compared them to simplified benchmarks of the S&P 500 and Barclay’s Aggregate which is fixed income. That used to be called the Lehman Ag. I still think about it as the Lehman Aggregate, rest in peace.
And what we found was that 70-80% of these 20 fund diversified composites outperformed their risk adjusted benchmarks. So that was a lot better than I thought I would see. Now not every hedge fund investor is diversified enough to own 20 funds. And we did the analysis where we reduced the size of the portfolio from 20 to 15 to 10 to only 5 funds and it was pretty striking. By the time you’re only owning 5 hedge funds, your chances of outperforming these risk adjusted market benchmarks is almost 50/50.
So there’s enormous correlation and diversification benefits to owning more hedge funds rather than less. And there’s also questions about survivorship bias and other things on the construction of these portfolios that we get into in the document.
But I did think it was interesting to share that for tax exempt investors with diversified hedge fund portfolios that the numbers looked a lot better than I thought they would.
On commercial real estate and office in particular, if there’s any good news, it’s that the office sector was declining in private commercial real estate portfolios even before COVID. And so even before COVID hit, that number used to be between 35 and 40%. In other words the average institutional private real estate allocation to office was 35 to 40% of the overall portfolio with the rest in apartments and industrial and hotels and things.
That number had already fallen before COVID to around 25%, thank goodness. And based on the work-from-home data that we’re seeing, for example, from Nick Bloom at Stanford, those numbers are still stuck between around 25 to 35%. So there’s, in recent months, there hasn’t been a lot of evidence of back-to-work-ism.
And that’s the reason why you’re seeing a spike in special servicing rates for office loans in securitized portfolios. But what’s interesting is the lack of a spike in special servicing which refers to delinquencies and preemptive modifications and workouts. What’s interesting is that we’re not seeing that big of a spike in special servicing for non-office loans.
And we have a chart, a document that shows that for hotels and retail other than regional malls, the delinquency numbers are actually getting better. So right now, though things may change, but right now in commercial real estate it’s very much a regional mall and office market disaster zone with better data elsewhere.
And I have a chart in here on B REIT. I just thought it was interesting to talk about it. It’s over a $100 billion fund. So we have a chart in here that shows the average amount—there’s been a lot of press on how many people were trying to get out of B REIT and that they were aping redemptions.
The pressure on B REIT has declined substantially. So we have two charts in here that looks at the amount of monthly requests for redemptions as a percentage of the NAV. And also what percentage of those requests have been fulfilled. And both of those series have gotten a lot better since the beginning of the year.
Look, why wouldn’t it? Like B REIT has less than 5% in office. So they’re definitely going to have some NAV issues related to rising interest rates. I don’t think they’ll have the collapsing NOI associated with a large allocation to office.
We have a page here on infrastructure. What’s fascinating about infrastructure is the debate about how much you actually earn by investing in it. And we have a chart in here that shows to providers of industry returns for infrastructure investors. I’ve never seen two series more dissimilar from each other than these two.
One of them is from MSCI. And it’s obviously extremely smooth. They’re just talking to a bunch of GPs who invested in infrastructure, accepting those valuations as a given, and constructing an index.
And then there’s another from called ED HECK [phonetic] which does some really interesting work. They similarly talked to GPs about what infrastructure assets they’re investing in whether it’s power, transportation, waste management, things like that. But then they look at actual transactions taking place in the industry and use that real world data to try to capture the changing valuations of infrastructure assets.
The total returns on both indices are similar. Their volatilities are violently different. And one of the things I always tell our clients is if you’re going to do risk adjusted returns or sharp ratios or correlations on illiquid assets using benchmarks which are smooth, you’re basically wasting your time and deluding yourself.
I wanted to just finish this podcast. We have a long section on the end on private credit. The private credit market has absolutely exploded in terms of asset under management, now over $1 trillion with lots of dry powder.
So what is it that’s leading people to invest in private credit as opposed to bonds and leveraged loans? Well we’ll see. But mostly it’s a story about yields. Now high yields tend to draw capital everywhere. And this is no exception. As of the middle of last year, direct lending which is another way of describing private credit, yielded a couple hundred basis points over US preferred stock and leveraged loans.
The private credit markets have been generally open over the last couple of years compared to syndicated leveraged loans which have large —
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Text, J.P. Morgan Asset Management.
(SPEECH)
Good afternoon, everybody. This is Michael Cembalist with the last Eye on the Market podcast for 2023. This is our biennial, which means “twice a year,” alternative investments review, and this one’s called “It’s Mostly a Paper Moon.” Anybody that’s around my age would remember the Paper Moon movie. And a paper moon refers to something that looks very real, but may be partially an illusion.
So, in this piece that you can read that was sent out today, we have information on private equity, venture capital, hedge funds, real estate infrastructure, and private credit. I’m going to go through just a couple of the findings on this podcast, but obviously, if you’re interested in any of those things in detail, you should take a look at the piece that we sent out. And let’s see. Let’s take a look at what we got here.
The first thing that jumped out at me was– and I work with someone named Steve Kaplan at the University of Chicago who aggregates a lot of private equity performance data. The last time we looked at this a couple of years ago, the recent private equity vintages were barely outperforming the public equity markets.
And we have some charts here that show that whether you’re looking at the average manager or the median manager, there’s been a noticeable improvement in performance in those 2016, 2017, 2018 vintage years of private equity compared to the public markets. And here, we’re showing a ratio of private equity to public equity outperformance or underperformance.
And so what we get into in the piece is a look at how did this happen. And obviously, the first place that we stopped here was to look at a surge in private equity activity that took place in exit activity that took place in late 2020, early 2021. And so part of the reason for improved in private equity outperformance was a lot of companies got sold at very high valuations.
And I think all private equity investors owe a giant thank you note to the IPO markets, and in particular, SPAC investors, because a lot of companies got sold at inflated valuations, didn’t do so well after they went public. And for those of you that read the IPO paper that we sent out in July of this year, that’s when we analyzed the aftershock of those companies going public.
But as it relates to private equity, a significant part of the improvement in performance versus public markets came from all the monetary and fiscal stimulus, which pushed up risk appetite and multiples and allowed private equity firms to sell a lot of the companies they had invested in, both good and bad ones. My biggest question is why some of the managers didn’t even sell more of the companies they held, given the conditions that prevailed at the time.
But the thing that struck me was even after looking at the impact of being able to sell a lot of companies at good prices, a lot of the value in these private equity returns that people are seeing are still on paper. And we have this chart in here and a table also in the document that explains what I mean by that, which is, if you look at, for example, the 2017 or ’16 vintage years, and you look at the percentage of the total NAV– that’s a function of distributions and, separately, a function of the remaining value of where positions are marked– both of those vintage years, more than 50% of the total value in the NAV is still a function of remaining positions.
So in other words, where those positions get marked and where those positions are ultimately sold in a world of higher interest rates are going to have a big impact on the ultimate performance and outperformance of those private equity vintage years. And that’s what I meant by the paper moon thing, which is, if you invest in a 2016 private equity fund, you might be tempted to think that seven years later, that the vast majority of your total economic value would already have been monetized. But that’s not necessarily the case.
Now, obviously, these are average managers, and there are wide exceptions on either side of this, but this is pretty good industry data for the median manager. And so, now, obviously, there are some questions to ask about where positions are both marked and where they’re ultimately going to be sold. I think if you look at average LBO purchase price multiples from 2004 to 2018, they were kind of around 8, rather than 10 to 12, which is where they were in recent years.
So there are some legitimate questions to ask about where those private equity vintage years, those performance numbers are going to be after the remaining positions are liquidated. I think Bain had an estimate that there’s close to $3 trillion of private equity companies that still have to be monetized in the next three to five years. That’s a lot of companies.
And we’re starting to see additional signs of distress of some of these private equity firms. One place to look is what’s happening in the loan market. And Moody’s estimates that around more than half of all B-minus-rated loan borrowers won’t be generating enough cash to cover both capital spending and debt service by the end of the year. So we’re starting to see some actual cash flow stress taking place in the loan market due to rising interest rates.
We were also seeing a big increase in amend and extend activity in the loan markets, which, basically, refers to preemptive extensions and amendments and restructurings and things like that. It’s running at its fastest pace since 2009. So while the NAV marks in private equity are adjusting slowly, underneath the hood, we can start to see– we are already seeing some turbulence there.
Similar story in venture capital. So in venture capital a couple of years ago, the 2016 and 2017 vintage years were just flat the public markets or even below. Now those valuations look better than public markets. And again, there was a surge in monetizations in 2020, and also, in particular, 2021, particularly for VC, because that’s when a lot of the SPAC issuance for health care and biotech and technology got done.
And as you can see here, I mean, this is kind of remarkable to go from, let’s say, $150 billion worth of venture capital exit activity in 2018 to $800 billion by 2021. A lot of companies got sold, and a lot of them didn’t do too well. So but despite that surge in monetizations in the venture capital industry, venture capital investors, on average, are even more exposed to ongoing market conditions than private equity investors. And we have a chart in here that shows let’s go back to that 2016 vintage year.
The average private equity investor for that vintage year has 50% of their total NAV subject to market conditions. For venture capital, in that same vintage year, it’s over 80%. So I did not expect to see these kind of results, but for the venture capital industry, the amount of unmonetized positions for a lot of these vintages are still really high. It doesn’t mean that the outperformance numbers are going to crater because, presumably, there’s some connection between both public and private markets.
But I just thought it was important for people to understand that if you’ve been investing in private equity, and in particular, venture over the last decade, a lot of your IRR or multiple of invested capital that you will ultimately ultimately earn is still on the table and subject to market conditions.
We have some charts in here that show that that some of those market conditions for venture are changing, practically a doubling of the median time between venture rounds, whether it’s from the seed round to A, or A to B or B to C, an increase in startup shutting down due to bankruptcy and liquidations.
And then we have a chart in here that’s going to take a couple of minutes for you to digest, but I think it’s interesting to look at. And it looks at, for example, in the series C rounds, just from 2022 to 2023, what percentage of new funding rounds were down rounds– in other words, the valuation applied to the company was down. So just over the last year, that went from only 5% or 6% of down rounds for C and almost 20% now.
And of the down rounds, the decline in post-money valuations went from 30% to 50%. So to put it in an English sentence, almost 20% of funding rounds for VC in 2023 were down rounds with an average valuation decline of 50%. So conditions are obviously changing in the VC industry.
Real quick, on hedge funds, we’ve done this exercise a couple of times before. And I was kind of surprised about how well the numbers turned out, given the narrative that you read about in the financial press. We took two different hedge fund databases. We randomly created a portfolio, diversified portfolios, with 20 hedge funds each.
And we just looked at the annualized excess returns over T-bills and the volatility of returns. We compared them to simplified benchmarks of the S&P 500 and the Barclays aggregate, which is fixed income. It used to be called the Lehman ag. I still think about it as the Lehman aggregate, rest in peace. And what we found was that 70% to 80% of these 20 fund diversified composites outperformed their risk-adjusted benchmarks. And so that was a lot better than I thought I would see.
Now, not every hedge fund investor is diversified enough to own 20 funds. And we did the analysis where we reduced the size of the portfolio from 20 to 15 to 10 to only five funds. And it was pretty striking. By the time you’re only owning five hedge funds, your chances of outperforming these risk-adjusted market benchmarks is almost 50/50. So there’s enormous correlation and diversification benefit to owning more hedge funds, rather than less.
And there’s also questions about survivorship bias and other things on the construction of these portfolios that we get into in the document. But I did think it was interesting to share that for tax exempt investors with diversified hedge fund portfolios, that the numbers looked a lot better than I thought they would. On commercial real estate, an office, in particular, if there’s any good news, it’s that the office sector was declining in private commercial real estate portfolios, even before COVID.
And so, even before COVID hit, that number used to be between 35% and 40%. In other words, the average institutional private real estate allocation to office was 35% to 40% of the overall portfolio, with the rest in apartments and industrial and hotels and things. That number had already fallen before COVID to around 25%, thank goodness. And based on the work from home data that we’re seeing, for example, from Nick Bloom and Stanford, those numbers are still stuck between around 25% to 35%. So in recent months, there hasn’t been a lot of evidence of back to work-ism.
And that’s the reason why you’re seeing a spike in special servicing rates for office loans in securitized portfolios. But what’s interesting is the lack of a spike in special servicing, which refers to delinquencies and preemptive modifications and workouts. What’s interesting is that we’re not seeing that big a spike in special servicing for non-office loans.
And we have a chart in the document that actually shows that for hotels and retail and regional malls, the delinquency numbers have actually been getting better. So right now, look, things may change, but right now, in commercial real estate, it’s very much a regional mall and an office market disaster zone with better data elsewhere.
And I had a chart in here on B-REIT. I just thought it was interesting to talk about it. It’s over $100 billion fund, so but we have a chart in here that shows the average amount– there’s been a lot of press on how many people were trying to get out of B-REIT, and that they were capping redemptions. The pressure on B-REIT has declined substantially.
So we have two charts in here that looks at the amount of monthly requests for redemptions as a percentage of the NAV, and also, what percentage of those requests have been fulfilled. And and both of those series have gotten a lot better since the beginning of the year. So and look, why wouldn’t it? I think B-REITs got less than 5% in office. So they’re definitely going to have some NAV issues related to rising interest rates, but I don’t think they’ll have the collapsing NOI associated with a large allocation to office.
We have a page in here on infrastructure. What’s fascinating about infrastructure is the debate about how much you actually earn by investing in it. And we have a chart in here that shows two providers of industry returns for infrastructure investing. I’ve never seen two series more dissimilar from each other than these two. One of them is from MSCI and is, obviously, extremely smooth they’re just talking to a bunch of GPs who invest in infrastructure, accepting those valuations as a given and constructing an index.
And then there’s another firm called EDHEC, which does some really interesting work. They similarly talk to GPs about what infrastructure assets they’re investing in, whether it’s power or transportation, waste management, things like that. But then they look at actual transactions taking place in the industry and use that real world data to try to capture the changing valuations of infrastructure assets. And the total returns on both indices are similar. Their volatilities are violently different. And one of the things I always tell our clients is, if you’re going to do risk adjusted returns or Sharpe ratios or correlations on illiquid assets using benchmarks which are smooth, you’re basically wasting your time and diluting yourself.
I wanted to just finish this podcast. We have a long section at the end on private credit. The private credit market has absolutely exploded in terms of assets under management, now over $1 trillion with lots of dry powder. And so what is it that’s leading people to invest in private credit as opposed to high yield bonds and leveraged loans? Well, we’ll see. But mostly, it’s a story about yield. Now, high yields tend to draw capital everywhere, and this is no exception. As of the middle of last year, direct lending, which is another way of describing private credit, yielded a couple 100 basis points over US preferred stock and leveraged loans.
And the private credit markets have been generally open over the last couple of years compared to syndicated leveraged loans, which have largely been closed. Now, at first glance, I think that’s a positive thing for investors in private credit because the scarcer credit conditions are, if lenders are more active or can maintain their activity, they can take advantage of scarcer credit conditions and get better underwriting terms and better yields and things like that. But ultimately, we’re going to have to see how this private credit adventure turns out at the end of the journey once we have a real default cycle.
We have the hope that lending standards and private credit are a lot better than they have been in the loan market. And I’ve written about this a lot. But over the last few years, the loan market basically surrendered, complete white flag with respect to terms and conditions to protect their loans. And the private equity sponsors, which are big drivers of what takes place in the loan market, were able to extract incredibly aggressive sacrifices of covenants from loan investors.
One of the most corrosive consequences of a decade of zero interest rates is that it destroyed the generation of people who underwrite loans. They were essentially forced by bayonet, by the Fed, to start doing anything to get yield. And that’s one of the underappreciated consequences of Fed policy, is that it destroyed all of these underwriting standards, which had taken many generations to build. And we have a chart in here that shows in the loan market, whether it’s covenants or restricted payments clauses, debt incurrence clauses, the requirements on asset sales to prepay loans, voting agreements, all of these things weakened substantially over the last 10 years.
Now, we have to hope that private credit did better because there’s evidence that the coupons that are being paid by private credit by private credit companies have been rising. We finally have some real world data on underwriting in the loan market versus private credit. And for the most part, it’s favorable to the private credit market.
Here, we have a chart. We have a number of charts in here. The simple one looks at the fact that the larger the loan size, the more sacrifice there tends to be on covenants. So if you’re operating under $500 million in terms of loan size in the private credit market, anywhere from 40% to 70% of those loans have what’s called “always on leverage maintenance covenants.”
And then there’s a great chart in here for people that care about this kind of stuff. And if you invest in private credit and leveraged loans– I would argue that you should– is that the private credit loans under 250 million generally have very tight restrictions on EBITDA add-back clauses, which essentially allows private equity sponsors to make up fanciful projections of future merger synergies, cost reductions, and things like that, to increase their cash flow estimates, which allow them to increase their leverage.
This is very important stuff in the lower intestines of credit originations. And we have a chart in here showing that the private credit industry, particularly the smaller ones, do a much better job protecting themselves than larger private credit or in the leveraged loan market.
So anyway, for people that are diving into private credit or have been, I think this is a must read section for you to understand how it all works. Thank you everybody for listening. The Eye on the Market outlook for 2024 will come out as usual on January 1. And I look forward to speaking with you all again then. So long.
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J.P. Morgan. Important Information and disclaimers.