Thoughts on private equity implied returns… not convinced

Although we do not invest in private equity we, nevertheless, have a view on prospective returns for the asset class and its position in a portfolio.

Private equity (PE) as an investment seems to have become increasingly popular over the last ten to twenty years. This seems to be not only because PE funds are extremely lucrative for their managers and for the major banks, as PE has also been increasing in popularity as David Swensen (former Yale Endowment Fund CIO) and the “Endowment Model” have gained notoriety.

The Endowment Model is best described in Swensen’s book “Pioneering Portfolio Management” (2000), encouraging investors to seek out and harvest the risk premia in, amongst other things, private equity.

Whilst “owner/principal PE” i.e. private equity investments in businesses owned and run by the principal has obvious and demonstrable benefits, we are less convinced of the attractiveness of “agency PE funds” i.e. funds of private equity investments run by a manager/bank.

Here’s why:

  • Firstly, there is now a very big body of research largely from the US, where the asset class has been around for longer and the data collected has been over a much longer period, which strongly suggests that PE returns are highly correlated to listed small cap public equity returns.

Back in 2009 the Brandes Institute published a paper titled “Is US Small Cap a viable alternative to US Private Equity?”; the results and conclusions of which have been repeated and replicated in multiple studies in the following years.

It concluded, “… based on long-term performance, small cap has been a viable alternative to private equity in seeking compelling returns”.

Of course, PE is less-liquid, more opaque and the search costs involved in finding and accessing good and persistently performing funds (when the average PE fund delivers returns no better than public equity returns) should also be borne in mind.

In addition, as Professor Ludovic Phalippou (Said Business School, University of Oxford), probably the leading researcher in the performance and risk characteristics of PE funds, has shown, the generally accepted method for performance calculation in PE funds systematically overstates PE fund returns.

As shown in his paper “The Performance of Private Equity Funds” (2009) “… a large part of performance is driven by inflated accounting valuation of ongoing investments and we find a bias toward better performing funds in the data. We find an average net-of-fees fund performance of 3% per year below that of the S&P 500. Adjusting for risk brings the underperformance to 6% per year.”

For those particularly interested, Phalippou has proposed an alternative, more rigorous method to the traditional “internal rate of return” calculation favoured by PE funds – see “A New Method to Estimate Risk and Return of Non-traded Assets from Cash Flows: The Case of Private Equity Funds” (2012).

So, the case that (a) PE fund returns are overstated and (b) PE returns are highly correlated with small cap returns, in our view, is strong and very compelling.

  • Secondly, at the risk of attracting a wave of abuse, it seems to us that a large part of the PE model seems to be buy a company, swap its equity for debt and leverage the balance sheet. Increasing the balance sheet leverage increases the return on equity and, all other things considered, that lifts earnings and thus lifts the price for re-sale. Simple – more debt = better.

In fact, that looks pretty evident in the data. The following chart shows net credit market debt issuance in the private non-financial sector (as a % of GDP) versus the US Small Cap Equity Index implied 10 year annualised return.


The chart is very striking. In the period from 1980 – 1990 there does not seem to be much going on, this changes abruptly after.

Starting around 1990, the correlation between small cap equity implied returns and net debt issuance is extremely strong.

As PE returns have a large debt component and are highly correlated with small cap returns and since small cap returns are highly correlated with small cap valuation, what we see is a debt/small cap valuation/PE synchronisation over the last twenty-five years.

The next chart shows the valuation of US small cap that corresponds to the implied returns in the first chart. Right now, small cap valuation, with net debt issuance running at 4% of GDP, is within a whisper of the highest levels ever and on par with 2000 and 2008… and we know about the PE investment returns for funds entered at those points (Preqin has the data, for a fee).

PE investments made at the top of the valuation cycle at high levels of net debt issuance are never, looking back, a good idea.


The same high valuation/low implied return position is evident in European small cap.

So, implied US small cap returns look unappealing, less than 6%, suggesting very unattractive returns for US PE. Although at least with a small cap stock portfolio it can be liquidated at will, something that cannot be said of a PE Fund.

The next time you consider PE, think if you might not be better off in a cheaper, highly liquid, transparent small cap ETF instead.



Implications of the China Crisis…

August 24, 2015

While in many cases a 38% decline in Equities from their mid-June peak, wiping out 16 months of gains in just 8 weeks, might have had substantial domestic economic effects – not least through the wealth loss in the Private Sector – the consequences of the decline in the Chinese market are slightly more subtle and global in nature.

A little background data might prove helpful; according to the China Household Survey of Finances, about 9% of Households participate in the Equity Market and Equities account for just 1% of Total Household Financial Assets. In comparison, Japanese, Euro and US Households have 10%, 18% and 33% of their Financial Assets in Equities. The loss of wealth and the direct effect on consumption in an economy of approximately $10 trillion and where Household Consumption is just 38% of GDP (versus 52% back in 1990) is, by any measure, modest. Moreover, the top quintile of Households by Income own over 90% of the Equities held by all Households and they have the lowest propensity, by far, to consume. China is just a little bit different.

So, what is the most worrying element of this whole affair?

As we have shown previously, the real problem of China lies in the fact that Manufacturing Productive Capacity Growth still substantially exceeds the rate of growth in demand globally. Domestic demand in the Euro area, UK, Japan and US is growing at just about 2.5% when Chinese Manufacturing Capacity is growing at almost four times that pace.

The gap is narrowing rapidly, and that is the source of the rapid slowing in Chinese growth, reflected in commodity prices, global growth and global inflation. However, it is still substantial and the excess that has been accumulated will take years to run-off.


The consequence of this huge overhang in potential supply is very clear when you look at the growth rate of Global Merchandise Trade in the last decade:

  • China accounts for a fifth of the growth in Global Merchandise Trade in the 10 years through 2013, with the Asian bloc as a whole at 43% (22% if we strip away Japan and China).
  • At the margin, China (and Asia) have made a hugely disproportionate contribution to the growth in World Trade in the last decade. In that period, global production rose 2.7% annually when trade grew 4.7% annually.
  • In the 5 years up to 2013, China accounted for 27% of the growth in Global Merchandise Trade.


In short, World Trade Growth has substantially outpaced production growth in the last decade and China has been a disproportionate contributor to that trade growth. China is the marginal provider of cheap goods – it is, in effect, the price setter in the global market for merchandise.

Now, if we add a devaluation to a massive overhang in capacity and the role of China as the marginal price setter globally, what do we get? Disinflation and Deflation.

China’s “out” from this slowdown – driven by years of debt accumulation, bank balance sheet expansion and grotesque over investment – is devaluation. The implication for the West is clear – deflation. This makes an exit from QE and a normalization of monetary policy almost impossible.

What is the impact of deflation on Equity markets?

Well, take a look at the following chart. We took one of the most reliable and commonly used valuation ratios – the Price/Trailing 10 Year Earnings – and looked at it over the last century and more versus US Consumer Price Inflation. You see something very interesting:

  • Over the whole period there is, as some have noted, a “sweet spot” for valuation – the blue bars have a distinct “hump” at the 5th and 6th inflation decile, which is when consumer price inflation is in the range 2.0 – 3.3%.  Note that valuation falls away quite appreciably when we get down into zero inflation and below that in the lower two deciles.
  • There is, however, some relief when we exclude the extraordinary period of the last 20 years and the bubble of 2000. Then we see that the “sweet spot” is, in fact, a consequence of a small number of observations around the 2000 bubble peak. Nevertheless, valuations do fall away noticeably at very low inflation/deflation periods (and at very high inflation levels).


So, if our analysis is correct and we face a period of intense disinflation/deflation, then a lower valuation for Equities would appear entirely appropriate. In the meantime, reluctant to pin all hopes on a forecast, we continue to “observe and infer” i.e. to respond to changing market conditions rather than try, frustratingly, to anticipate them.



Gold… it’s not the US Dollar!

July 27, 2015

With Gold hitting its lowest level since late 2009, we are reading more and more commentary attempting to determine the cause of its recent weakness. Many have labelled its decline as a consequence of a stronger US Dollar, which itself is a consequence of expectations of forthcoming US Fed rate hikes. Once again the words of Thomas Huxley spring to mind: “The great tragedy of science – the slaying of a beautiful hypothesis by an ugly fact

For the sake of argument, for a UK-based investor, the following simple equation describes the relationship between the price of Gold and the US Dollar/Pound Sterling (USD/GBP) exchange rate:

  • USD/Ounce of Gold = USD/GBP   x  GBP/Ounce of Gold

So, the price of Gold goes down when

  1. USD goes up


  1. GBP price of Gold goes down

Clearly, it is, in principle, not the case that the US Dollar going up necessarily implies that the price of Gold goes down.

In fact, if we look at the spot price of Gold (in US Dollars) versus the USD/GBP exchange rate (monthly % changes) we see that there is no relationship at all over the last 20 years (the same is true looking further back).


And using the same chart but showing instead the spot price of Gold (in US Dollars) versus the change in the USD/Euro exchange rate (Gold from the perspective of a Euro investor)… again, no relationship (R2=zero).


Our hypothesis remains the following:

  • Gold has been an effective systemic and catastrophic credit risk hedge – you hold it when you fear for the very survival of the system. To that end, the Gold price has been highly correlated with credit default swap spreads (think of credit default swaps as insurance policies, the price aka “spread” rises/falls as perceived credit risk rises/falls).

The following chart shows a GDP-weighted average of the Credit Default Swap (CDS) spread for Italy and Spain versus the price of Gold during the recent boom and bust period for Gold. You can see the price of Gold surged higher as CDS spreads widened (systemic risk rising) from 2008 – 2011 and then fell from 2011 onwards as CDS spreads narrowed (systemic risk eased). The CDS spread narrowed sharply in the period after 2011 when central banks went “all-in” on QE and effectively “guaranteed” the liquidity (and solvency) of the financial system. The full scale shift to QE by the ECB this year explains the move in Gold, in our opinion, not the US Dollar.

The Gold price is now pretty much where CDS spreads suggest it should be.


What would cause Gold to surge higher again? The (unlikely) abandonment of QE and a decision by central banks to leave the massively debt-laden system to fend for itself.



Gold Miners: The day of reckoning approaches

July 23, 2015

Involvement in less regulated markets comes with its own risks. Markets participants were reminded of that when in the early hours of Monday, the 20th of July, the price of Gold plummeted by just over $45 an ounce (-3.9%) in less than a minute just before the market opened in China. This price action, caused by a massive sell order of $2.7 billion in Gold futures, looks an awful lot like market manipulation since no one in their right mind would try and sell such a large amount so quickly at the lowest liquidity point of the day. If a short-seller with deep pockets wanted to re-price Gold significantly lower, he would follow exactly the same modus operandi.


For Gold miners, this is of course bad news. After a golden decade (2001-2011) – no pun intended – when the market rewarded aggressive growth over cash flow generation and financial discipline, their fortune has changed dramatically. As the market for Gold peaked just below $2000 per ounce, investors came to the realisation that despite the yellow metal being in excess of 6x higher than 10 years before, Gold miners’ cash flow generation in aggregate was flat.

Fast forward 3 years and the situation has deteriorated quite dramatically. The chart below (courtesy of Goldman Sachs) shows the all-in cost of production (including net debt and interest due as well as operational expenses) for the major players of the industry. In effect, this shows that prices per ounce below $1050 would mean that an overwhelming proportion of Gold miners would be making a loss. The top 10 global miners also show leverage ratios (debt: equity) in the region of 100% on average. As the odds of higher interest rates in the US increase, access to financing and interest payment should worsen, adding financial stress to an already challenging operational situation.


Unsurprisingly, investors have started voting with their feet as the price of Gold approaches the $1050 – $1100 territory. Between August 2011 and June 2015, Gold miners showed a Beta of 1.6x to the price of Gold. In practice, this means that when Gold sold off by $1, Gold miners sold off by an average $1.6.

Since the beginning of the month however, this sensitivity has doubled, as Gold miners now sell off by an average $3.1 for each dollar lower in the price of Gold. This makes sense, since each dollar lower in the price of Gold exponentially increases the risk of insolvency, and ultimately bankruptcy, of these companies.


In due course, distressed investors with the nerves to get involved will be able to acquire Gold-related assets at a significant discount to fair value. The day of reckoning approaches, but things will probably get worse before they get better. Especially since the recent price action will in all likelihood spur the deep-pocketed trend-following community to increase their short positions, adding incremental pressure for lower prices to an already very weak market.



Industrial Metals Anyone…?

July 20, 2015

There is an interesting picture developing between Emerging Market Equity Performance and the Performance of Industrial Metals Prices.

The chart below shows the % Drawdown from the trailing peak level of the GSCI Industrial Metals Index (Aluminium, Copper, Zinc, Nickel and Lead) and the MSCI Emerging Equity Index.


There is an extremely high correlation until 2012… then there is a marked divergence. Why is this?

Look at the aggregate level of the inventory of Industrial Metals in the LME (London Metal Exchange) warehouses (metric tonnes).

Aggregate inventory is 73% Aluminium – Aluminium stocks have fallen 30% from their peak in late 2013 and are down 29% year/year.


Short Emerging Equity/Long Industrial Metals anyone? …Inventories of Industrial Metals are falling fast!



Why Greece cannot be Japan… or why Japan is not Greece (yet!)

July 16, 2015


  • Greek Debt/GDP Ratio is currently around 180% and, more importantly, the Greek Government Debt/Government Tax Receipts Ratio is 600% (6 x). These debt ratios will, of course, rise further after the bailout.
  • Greece is close to primary budget balance (it was 1% in primary surplus late last year and has a cyclically adjusted primary surplus of approximately 6% of GDP). The Greek 10 Year Yield is around the 12% level.
  • Greece has a current account surplus.


  • Japanese Debt/GDP Ratio is currently 230% and, more importantly, the Japanese Government Debt/Government Tax Receipts Ratio is 2200% (22 x).
  • Japan has a primary budget deficit of 7% of GDP and a cyclically adjusted primary deficit of 6% of GDP. The Japanese 10 Year Yield is 0.44%
  • Japan has a current account surplus.

Japanese Debt is approximately 22 x government tax receipts while in Greece it is 6 x government tax receipts. Japan also runs substantial structural deficits. This raises the question, why is Greece in crisis and Japan, with yields near zero, not?

Simple, monetary autonomy – having your own central bank.  The chart below shows the benefit of this.

2015.16.07 BoJ Debt

The Bank of Japan is accumulating vast amounts of bonds, it has gone from owning 7% of the outstanding stock two years ago to almost one quarter today.

So much for monetary autonomy, you truly can pretend there is no problem when you have a friendly central bank to buy your debt…



Greek Default priced in

July 3, 2015

If you assume that the German Benchmark Yield Curve represents the Eurozone Risk Free comparison, then the spread of Greek versus German Bond Yields can be used to calculate the “Implied Probability of Default” already discounted by Greek Bonds at various assumptions for the Recovery Rate (the amount of money you expect to recover after default).


The 5 year Greek Bond fully discounts default with a 50% recovery rate, as do the 10 and 30 year Greek Government Bonds.

The 10 year Greek Bond fully discounts default with a 25% recovery rate, as does the 30 year Greek Government Bond.

Easy to see why some Hedge Funds have taken a position… default pretty much fully priced at these levels across the curve with half recovery; not an unrealistic expectation.

A 2009 Moody’s publication “Sovereign Default and Recovery Rates, 1983-2008” found for 13 defaults a value weighted recover rate of 30-40% (depending on method). Either way, with that type of recovery rate in Greece, default is fully priced in…



“Are we nearly there yet …?”

May 13, 2015

The continuing saga that is the Greek debt crisis and the surprisingly convincing Tory election win in the recent UK elections, once again focuses the spotlight on the sustainability of budgetary positions and prospects for further fiscal policy tightening (“austerity”) in the major economies.  It begs the question, “Are we nearly there yet, or are we still on the road to austerity?”

The question has importance for two main reasons: 1) it tells us about the magnitude of potential growth headwinds and 2) since Quantitative Easing liquefies assets in the banking system, and in the process removes government liabilities from the market, it necessarily diminishes government debt market liquidity.

Chart 1 shows the level of general Government primary net lending/borrowing, that is the net borrowing/lending when interest costs are excluded: the data is a percentage of GDP.

2015.05.13 Blog Chart 1 Pic

The chart also shows, assuming these economies maintain the growth rate of last year and can continue to finance at current exceptionally low levels of real yields, the degree of fiscal policy tightening required (the “shift”), or permissible easing, that would stabilize the net debt/GDP ratio at the level of last year. Several things stand out:

  • While Greece is running a primary surplus (its cyclically adjusted surplus is around 7% versus the current surplus of 1%), albeit modest, as it did from 1994-2002, the additional tightening required to stabilize its debt ratio is 5.9% of GDP.
  • The UK currently runs a primary deficit of almost 4% of GDP (it has run a surplus in 6 of the last 25 years and a deficit now for the last 13 years) and requires additional tightening amounting to 3.7% of GDP, or £66 bn, from the new government in order to stabilize the debt ratio. That would mean some harsh choices – the required shift is the equivalent of 45% of spending on public pensions, 50% of the NHS budget, 73% of the schools budget, 60% of the social   security budget and almost 150% of the defence budget, give or take a few pounds. It is approximately 9% of total UK government spending.
  • Both France and Spain also require sizeable additional tightening in order to stabilize debt ratios, 2.4% and 3.3% of GDP respectively, just shy of €90 bn in aggregate.

Chart 2 illustrates what happens if we extend the analysis to include the US and Japan.

2015.05.13 Blog Chart 2 Pic

  • Japan, with a current primary deficit of 7% of GDP, requires a 4.5% of GDP fiscal policy tightening, at near zero bond yields with Bank of Japan QE amounting to 15% of GDP annually and giving them a current holding of one-fifth of the outstanding debt stock, just to stabilize the debt ratio.
  • Even the United States requires a further 3% of GDP fiscal policy tightening from here to stabilize its debt ratio.

Interestingly, Germany could afford to ease fiscal policy by 2% of GDP under our assumptions and the debt ratio would be stable. That, in our opinion, seems quite unlikely.

Adding the required shift/tightening together for these 10 countries gives us a €800 bn fiscal policy tightening in aggregate in order to stabilize government finances across the board.

That would be an extraordinary headwind to a global economy where the median real growth rate is currently just 2.3% and median core inflation rate is just 1.1%.

Even if you relax the growth assumption in favour of a far, far more optimistic assumption that these economies can grow at the fastest annual rate that they have managed in the last 20 years, the required fiscal tightening is still in the order of €700 bn. Whatever way you cut the numbers, we can safely say we are still on the road to austerity. That means, of course, the risk of a monetary policy “mistake” is severe – at exceptionally low inflation rates monetary policy must accommodate fiscal policy, not fight it.

It is the US… again!

May 8, 2015

The last two weeks in financial markets have been somewhat of a rollercoaster, with bonds, stocks and the US Dollar selling off in unison, wiping out several hundred billion dollars off global wealth in a matter of days. European bonds took a severe beating, which, as explained in one of our previous blogs, was inevitable considering that a large proportion of them were trading at prices that guaranteed a loss at maturity.

Panics in financial markets always show up unannounced, which makes it all the more interesting to understand ex-post what triggered these brutal moves. Friends of MONOGRAM have heard us mention many times that in essence, this is all about the US. The US drives capital and sentiment, and are therefore more often than not the culprit behind volatility bouts. All major crises in the last 30 years have started in the United States: the 2008 Lehman debacle, the 2000 Tech bubble, the 1998 LTCM bailout, and the 1987 market crash.

This time around, two factors seem to have been the catalyst behind the coordinated retreat in assets markets. First, a couple of fixed-income investment luminaries, Bill Gross of Janus Capital and Jeffrey Gundlach of DoubleLine Capital (who incidentally are both American), have been vocal about the inflated valuation of European sovereign bonds. Gross going on to call long-dated German bonds “the short of a lifetime”. This means that betting on these bonds going down is effectively almost a sure bet, the closest thing to free money.

Secondly, the US economy is going through a bit of a soft patch. This should in theory be favourable to bonds, and perhaps not so good for equities, but both asset classes have gone down. Why? Mostly because the US Federal Reserve said that this would not change its perception of the overall upwards trajectory of the US economy, and therefore it would not change its plan to tighten monetary conditions by the end of the year.

But perhaps the Federal Reserve is wrong. Perhaps the US, which has been expanding modestly over the last 6 years, is starting to turn the corner for the worst. This of course, would be supportive to bonds, although interest rates are so low that upside here is limited. This would also be a headwind to stock market performance, not only in the US, but also in Europe; and this is even if European economies finally break out of the stagnation world it has been living in for years.

Why is that? Because the US economy actually has a much larger influence on the fate of developed markets than the local economies themselves.  This means that what matters most to the performance of say, UK stocks, is not so much whether the UK is in recession or not, but whether the US is in recession or not.

To show this, we look at the performance of 5 local markets on a quarterly basis, selecting only the quarters when (i) the US was in recession, but not the local markets, and (ii) local economies were in recession, but not the US. Our sample includes France, Germany, Italy, Spain and the UK. Going back to 1992, our findings are crystal clear. The simple average annualised performance of local markets when we observe:

  • Local expansion and US recession is -22.0%
  • Local recession and US expansion is 13.1%.
1992 – 2015 Annualised Local Markets Performance
US recession France expansion -25%
US recession Spain expansion -13%
US recession UK expansion -21%
US recession Germany expansion -30%
US recession Italy expansion -20%
US expansion France recession 21%
US expansion Spain recession -1%
US expansion UK recession 21%
US expansion Germany recession 20%
US expansion Italy recession 5%

In light of these results, it is certainly worth keeping a very close eye on the fundamental US dynamic- and hope that the Federal Reserve is right. As former US President Bill Clinton once famously said- “It is (about) the economy, stupid”. That is right, it is about the economy … of the US.


Growth & Momentum Everywhere

March 26, 2015

In 2009, Clifford Asness, Tobias Moskowitz and Lasse Pedersen published a paper titled “Value and Momentum Everywhere”. The rationale behind their analysis was simple – value bias investing generates returns that are lowly, or even negatively correlated with a “momentum” style of investing. Value investors invest in stocks that are fundamentally cheap, whereas momentum investors allocate capital on the basis that what has gone up should continue to go up. Diversifying your portfolio across stocks exhibiting a value profile and those that have had strong momentum behind them will likely generate better risk-adjusted returns than investing in either of these styles in isolation. The sweet spot is in finding stocks that combine both styles. This is perhaps why Apple has been a hedge fund darling for so long; it has been showing lower than average cash flow, earnings and sales multiples when compared to competitors and the broader market while enjoying a powerful momentum that has propelled its share price up by a factor of 25 in 10 years.

Intuitively, this approach makes sense – if a stock is cheap and starts to go up, perhaps it is on its way to correct its cheapness. If this is the case, it should outperform its peers and the broader market once this is corrected for. In addition, financial practitioners know that sources of diversification in equities are rare, and anything that lowers the risk of one’s portfolio while keeping its expected return constant is worth having. In combining value and momentum, a portfolio manager can have his or her cake and eat it too, in theory.

Sadly, this beautiful concept finds substantial limitations in everyday investing. We find that value as a style works well, but only if the investment window reaches several years – at least according to professor Robert Schiller at Yale.  He argues that the minimum window of value investments should be 8 years, with better results for those willing to invest over a period twice as long. Besides, value only offers a long-term premium when applied to very small stocks as pointed out by Israel and Moskowitz at AQR Capital, a large US-based asset management firm run by Asness himself.

Along with Kent Daniel, a scholar at the Kellogg School of Management, we find that the growth style of investing combines much better with momentum than with value to generate excess returns. Consider this, a portfolio of the stocks that rank highest according to momentum and value metrics has generated 100 bps of excess performance over the S&P500 in the last 10 years. This, however, comes with a larger maximum drawdown of -55.5% vs. 52.6% for the S&P500. By contrast, a growth and momentum portfolio of 10 stocks has beaten the S&P500 by an average of approximately 18 percentage points per annum over the same period. This also comes with a lower maximum drawdown (-41.8%).

Beyond the real-world shortcomings of combined value and momentum investing, at MONOGRAM we believe that the prism through which Asness and his colleagues look at these issues is indicative of the faulty way the financial community addresses these issues. We believe that drawdown, and not volatility, is the true measure of risk. This is because our investors care much more about the risk of losing a large chunk of their capital (“drawdown risk”) than the day-to-day capital markets turnings (“volatility”). With no offense to Mr. Asness, since combining value and momentum reduces the volatility of a portfolio without reducing its drawdown risk, it is of little practical interest to us. Momentum does that alone, as an enormous amount of literature has repeatedly shown, and we see little upside in polluting its benefits by combining it with a value filter.