Which is the Leviathan?

whale in the sea - sometimes called Leviathan

This is a week to ponder the role of private equity in portfolios, in what may be an early phase of a great investment and technological explosion. There seems to be no sign of higher interest rates and a stubborn refusal by Central Banks to care much about inflation. The talk of a UK raise always looked to us like a head fake which we ignored.

Spotting good and bad private equity

So first to private equity, a beast that comes in many guises, not all benign from an investor viewpoint. All liquidity fueled equity explosions come with a heavy loading of chancers; Bonnie and Clyde’s rationale for bank robbery remains valid.

Good private equity relies on management being superior to that of their targets. This can be in their analysis, their execution, their swiftness of foot or their innovation. All of this generally flourishes away from the hidebound inertia of many listed companies and their professional Boards of tame box tickers.

Bad private equity uses accounting tricks, the malleable fiction that the last price is the right price in particular, and the terrible phrase “discounted revenue multiple” which is a nice conceit for “never made a profit”. All of these share the same vice of management marking their own work.

So, we struggle with the likes of Scottish Mortgage and its little array of unquoted Chinese firms, the alphabet soup of non-voting share classes and love affair with management. Maybe they are that skilled, but nothing that looks like a real two-way market is evident to us, in many of these valuations. We have by contrast long admired Melrose Industries for their quite ruthless devotion to turning over their investments, good or bad and stapling executive pay to actual cash realizations paid to investors.

Where we stand – given our strategy

For an Absolute Return specialist there are added constraints: we want to hold under twenty positions altogether and all in ones we can sell tomorrow afternoon. And we like holdings where valuations are transparent, there is no gearing (there is usually quite enough in the private equity deals already), and you can pick them up for a fat double digit discount: oh, and we do like a yield too.

So, we are looking for big, listed options with hundreds of high-quality funds bundled together and for any yield, a bias towards management buy outs. We are certainly not at the venture capital end, with silly pricing, high fail rates, unrealistic managers, and not a decent accountant in sight and aspirations to change the world. Met those, invested in too many, and donated more shirts off my back than I care to enumerate to their serial failures and inexhaustible funding rounds.

But there are good things about Private Equity, one is that in a rising market, it can be like clipping a coupon. The accounting rules require them to be backward looking, so coming out of a trough they are typically reporting on valuations that are three or four months old, which in turn reflects business activity up to six months old. As they trade at a discount of typically 25% or so, you can buy today at a 25% discount to the value of the business they were doing in the spring. There are no guarantees, but for most, that was a lot worse than current conditions, so today’s price is simply wrong. This is a time machine that lets you buy now but pay at old prices.

Watch for built in volatility in private equity

These lags are complex, the reference points are often public market valuations, and so there is volatility built into them. While in an Absolute Return fund, not only are choices limited but the overall exposure must be too. However, in those rare purple patches of fast recovery and expansion they are excellent for performance.

What kills these bonanzas off is tight credit. In part they need debt for trade, but also their realizations rely heavily on it. A closed IPO market does them no good (just as they enjoy an exuberant one). That is a risk, as liquidity starts to tighten, that this will hurt, but as Powell and the Bank of England both showed, there is no political appetite for that just yet.

The UK and US on taming the leviathan

Indeed, Sunak’s UK budget yet again feels reckless, devoid of any discipline and with every department cashing in. Government spending is predicted to rise to 42% of GDP by 2026, a fifty year high. Healthcare alone is predicted to have grown by 40% in real terms since 2009 (both estimates from the oddly named Office for Budget Responsibility). At that level of loading, it is inching closer to hollowing out the entire budget and causing it to implode. (Leviathan was just such a creature “because by his bigness he seemes not one single creature, but a coupling of divers together; or because his scales are closed, or straitly compacted together” feels an apt description of this new giant state apparatus.)

But that gamble means there is no room to pay higher interest rates, or the economy will be reduced to a double-sided monster. The one face devoted to raising debt and levying taxes and paying interest, the other to feeding out of control public spending, with nothing left in between.

Thanks in a slightly odd way to a Democrat Senator, America has avoided throwing itself under that same bus, but with no effective political opposition the UK is now powerless to resist. Sterling’s relentless decline from the summer high and a FTSE 100 index still below its pre-COVID peak signify what markets feel about all this.

This is a graph illustrating how the FTSE index is not back up to its pre-Covid high, on 7 Nov 2021. This helps us look at private equity as an option.

From the London Stock Exchange graph

So, while we were more bearish than we have been all year, in terms of asset allocation, at the end of October, we have yet to call time on the Private Equity cycle, that has provided such a powerful boost this year. It still feels good value to us.

Of course, we recognize too, that the populist fear is of the wealth creators and an opposing adoration for wealth consumption. Unlike politicians, however, we are tasked with producing real results not vapid dreams.

I guess we can each choose which to regard as the leviathan – the burgeoning state, or private equity.

Charles Gillams

Monogram Capital Management Ltd