“Loading up companies with borrowing at a time of peak economic
uncertainty allows private equity groups to de-risk their own exposure
by taking cash out of the business. But the higher risk of defaults has
consequences for stakeholders beyond the private equity owners.”
– Financial Times, September 2020
Winter came a few months early last week, as Snowflake (SNOW) had a
highly successful Initial Public Offering, rising over 111% from its
offering price in its first day of trading to a cool market cap of
$67.4B. With eight rounds under its parka
belt prior to last Wednesday’s IPO, the mountain-top ascent was a
highpoint for a number of private investors, some of whom invested in
the company as early as 2012. Of course, not all private investments
turn out so successfully, but the rapid growth story underscores an
important phenomenon that is the subject of this week’s newsletter from
Louis-Vincent Gave: the willingness to trade liquidity for the potential
of income or growth.
Investors that participated in Snowflake’s Seed Round in 2012 were
likely expecting to have their capital tied up for at least ten years,
which has become the average timeframe from founding to exit for
fledgling venture capital-backed companies. Private investors that
participate in the early innings of a company’s development today likely
have (or at least should have) similar expectations. However, a lot has
changed in the world since 2012, and it’s worth wondering why capital
continues to chase illiquid investments in the midst of unparalleled
uncertainty.
As Louis outlines, the hunger for income (i.e. a stable return on
capital in the form of dividends or interest) and growth (i.e. outsized
returns in the form of a company’s market value appreciating) are two
key drivers. The insatiable appetite for return in a near-zero yield
world for US treasuries has pushed capital towards non-publicly-traded
investment areas such as private equity (PE) and venture capital (VC)
recently. This is in spite of the fact that private equity experienced
its largest loss since the Great Recession in the first quarter of 2020.
However, as shown in the chart below, both PE and VC returns rebounded
in the second quarter of this year, which has likely been a catalyst for
ongoing in-flows into them.
The question becomes, is this type of illiquid asset allocation a
successful strategy for today’s investors? Read more below to find out
what Evergreen Gavekal’s Partner, Louis-Vincent Gave, thinks about the
willingness to trade liquidity for the potential of future income or
growth.
Illiquidity and Creative Destruction by Louis-Vincent Gave
Covid came as a shock to the world, but in many cases it is merely
accelerating fundamental trends that were already unfolding anyway. The
US-China rift, the debasement of western currencies, the
de-dollarization of emerging markets, the attempts to replace carbon
energy with renewables, the increase in social tensions linked to living
in multicultural societies: everything now seems to have gone into
hyperdrive.
This probably shouldn’t be a surprise. If there has been one constant
theme in Gavekal’s research over the last 15 years or so, it is that we
are living in an age of accelerating creative destruction. This idea is
the common thread that ties together the books Charles and I have
written, from Our Brave New World, through A Roadmap For Troubling Times, to Clash Of Empires, and it is one most clients seem happy to agree with.
And this forces us face-to-face with an almighty capital allocation
paradox. As the world changes at an ever-increasing rate, and the future
becomes ever more challenging, more and more money pours into private
equity funds and other forms of locked-up investments. This is odd. In a
world in which the future is increasingly uncertain, surely investors
should be avoiding illiquid strategies like the plague, and instead
falling over each other to seek shelter in the financial industry’s more
liquid offerings? Instead, we are seeing precisely the opposite.
To take one example: a year ago, owning an office building in Midtown
Manhattan, London’s Canary Wharf or downtown San Francisco might have
seemed as “safe as houses”. But in the age of the unexpected, what was a
sure bet yesterday can turn into a certain loser today. Just look at
UnibailRodamco-Westfield, one of Europe’s largest office and commercial
property landlords. In two years, it has seen its market capitalization
collapse from €27bn to €4.2bn. Two years ago, owning commercial and
office space seemed like a good idea. Today, it is toxic.
Alternatively, consider an investor who in January 2000 decided that
new technologies were bound to change the way we live, work and play,
and that the way to play this change was to put capital into the 10 tech
companies with a market cap at the time of over US$200bn (figuring that
size and scale would be the key drivers of long-term performance). Our
investor would have bought Microsoft, Oracle, Intel, IBM, Cisco, Lucent,
Ericsson, Nokia, Sun Microsystems and Nortel Networks.
Reinvesting all his dividends, he would have ended up two decades
later with one winner (Microsoft), three washes (Oracle, Intel and IBM),
three big disappointments (Cisco, Nokia and Ericsson) and three donuts
(Lucent, Sun Micro and Nortel). His total compound annual growth rate
(dividends included) would have been 1.4%. And he would have missed out
on the likes of Amazon (with a November 1999 peak market cap of US$35bn)
and Apple (US$23bn in March 2000).
Clearly, in a single generation, the tech world has changed almost
beyond recognition, and the companies which offered scale 20 years ago
mostly failed to cope with that change despite all the advantages of
size (or perhaps because of them?).
This makes investors’ enthusiasm for illiquidity all the more
strange. Why, in a world that is changing so fast, would investors rush
headlong into illiquid strategies?....
