Welcome to the twenty-third Pari Passu newsletter,

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Today, we will learn more about:

1. 2023 Bain Private Equity Report

2. Invest Like the Best with David Einhorn - Founder of Greenlight Capital

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2023 Bain Private Equity Report

Every year, the consulting firm Bain publishes a private equity report which is widely known as one of the best pieces of information out there on the state of the industry. You can find here the PDF and the webinar links. Below you will find my notes and summary of the report, but I believe that everyone will learn a lot from watching the webinar (especially incoming first-year analysts about to start interviewing for private equity roles). Every graph and metric below is taken from the above report and webinar.

The year 2022 was a tale of two halves, a strong first half and a much weaker second half. A key transition moment was the Fed's decision to raise rates by 75 basis points in June 2022. Other reasons behind the weaker second half of the year are a series of events that we rarely see at the same time which lead to increased uncertainty in the market. In particular, inflation is something that most of the industry professionals working in private equity have never worked with, given the low inflationary environment we have seen for the last 40 years.

As you can see on the graph above, things do not look weak overall. The problem is that $550bn of the $654bn of volume was already agreed on in the first half of the year. Therefore the slowdown in the second half was truly significant.

Another interesting trend is that syndicated LBO loan issuance was down 50% from 2021. Syndicated loans are a type of financing provided by banks that is usually the largest and most senior form of financing for a private equity transaction. Syndicated means that a bank will front the capital for the loan so that the deal can be closed, but then sell off part of the loan to third parties (hedge funds, pension funds, etc.). This debt will then sell on the secondary market and there will be pricing for these tranches. The bank does not want to keep the debt on its books, and issuing the debt and then syndicating it presents some risks, especially in a volatile environment. Fortunately, the private credit markets were able to provide direct lending to middle-market firms. This said, banks usually provide financing for larger transactions, therefore volume is going to be down when they reduce how much financing they provide.

A few years ago, the industry believed $1tn of dry powder was a large amount. Now, dry powder sits at $3.7tn, so there clearly is a lot of capital to go around. As a consequence, multiples have not contracted in 2022, and they are unlikely to go down in the short term.

The graph above shows the exit value for private equity which means who did the private equity firm sell to at the end of their holding period. IPO means that the private equity firm brings the company public and progressively sells its ownership to public markets. Sponsor to sponsor means that they sell to another private equity firm and sponsor to strategic means they sell to an operating firm (Apple, Amazon, etc.). The graph shows how exits were driven by strategic buyers given that private equity firms were much more cautious to deploy capital.

From an LP (the investors that give capital to the private equity firms) perspective, the lower volume of exits implied that the cash flow turned negative. Meaning that investors were asked for more money (this happens when a PE firm buys a company and needs capital to finance the deal) than how much they received (this happens when a PE firm sells a company and distributes proceeds).

On top of the high level of dry powder, capital raised was high in 2022. This was in part attributed to the high commitments agreed at the beginning of the year. Bain argues that this large amount is an example of the long-term interest that LPs have in the private equity industry. Despite the high overall capital raised, fundraising was much harder; this can be seen as less than 20% of funds (compared to 40% in 2017) closed their funds on or over target in less than one year.

In 2022, public markets fell around 20% in developed countries. On the other side, GPs (private equity firms) are telling their investors that the value of their holdings is flat year over year on average. Two natural questions come up:

1. Why would this be so?

   1. Over the last few years starting during the pandemic, there has been a gap between equities and private equity valuations. This could be because of a lag, but maybe it is something else causing a long-term difference. A possible reason is that Apple, Microsoft, Alphabet, Meta, and Amazon drove around half of the decrease in the S&P500 in 2022. General partners argue that PE firms invest in more late-stage software (compared to technology) businesses that have a more critical product that is less volatile with overall market conditions.

2. Do I as an investor believe it?

   1. History says that when it comes to valuation, GPs tend to be conservative, and valuation on exit is often higher than the last quarterly mark. This could also be because GPs want to deliver good news when they exit their investment. It would not be great to mark companies at a certain multiple and consistently exit companies at a lower multiple.

   2. Over time, PE returns have been superior to returns in public markets. Therefore LPs have learned to trust the GPs.

In addition to the above mega trends we are seeing, Bain looked into three other trends.

1. Retail Investing

Institutional capital has much more access to alternative allocation (which includes private equity) compared to private wealth. There is still room to move up for institutional capital in terms of alternative allocation. Especially for investors who do not have a strong need for liquidity (like sovereign wealth funds). There is still a large amount of private wealth that has the potential to become alternative asset investors. These two trends, according to Bain, make the future prosperous for private equity given the potential capital inflow in the industry. Global alternatives AUM could go from current levels of $30tn to over $60tn by 2032. A quarter of that amount could be provided by private wealth investors given that there is a current mutual interest in making this happen. Private equity wants more capital to deploy and private wealth investors want access to these types of investments.

Another interesting data is that there are around 21,000 US companies with over $100mm in annual revenue. Only 15% of those are public. If I am an individual investing in the US economy, I do not have access to 85% of the market. In addition, private investors are eager to get reduced exposure to public markets, downside risk protection, income generation, and portfolio diversification.

2. Energy Transition

Investors are finding ways to put capital into energy transition. Capital is going into energy (renewable energy), mobility (batteries, efficient transport systems), clean industries (waste management, circularity and recycling), and building infrastructure (water management, sustainability consulting). This trend includes infrastructure funds, buyout funds, and growth funds competing with each other.

Interestingly, private and PE-owned companies have on average lower carbon scores compared to public companies. This said, there is increasing pressure from investors to see portfolio companies adopt carbon-reduction strategies that are relevant and measurable.

3. Web 3

Web 1 was the information economy 25 years ago, with read-only information (Yahoo), Web 2 was more dynamic, with people talking back to the internet (Facebook). Bain defines Web 3 as the new generation of the internet built using decentralization, the internet owned by builders and users, orchestrated with tokens. There is a trust environment without an intermediary. $100bn has already been invested in this sector, especially in companies building the infrastructure that Web 3 is based on.

This is firstly an investment theme, financial services have the potential to see major disruption. In addition, this is a disruptive threat to the portfolio given the unknown impacts of the new technologies. Finally, this could be a tool for new funds strategies that want to take advantage of the transition and become liquidity providers for these Web 3 businesses.

Finally, Bain looked at factors affecting the industry in the near term:

1. Demographics: labor markets are likely to be tighter over the next decade because populations are aging. This leads to higher stress given that the same workers have to take on a larger workload per capita. This will lead to higher costs.

2. Government budget pressures: the older population will lead to a decline in the ratio of tax-paying workers to retirees. This will lead to increasing fiscal pressure. Businesses with high revenue exposure to government payors may be challenged.

3. Material costs: the general shift to onshoring supply chain (to reduce the risk of production) may increase input costs. This would be added to the potential energy expenses associated with transitioning away from fossil-fuel sources.

4. Interest costs: we had an environment with basically no interest rates, but now central banks have indicated that this is not going to be the case anymore leading to higher interest rate costs on the debt used to finance private equity transactions.

Overall, the industry went through a rough few quarters, but the long-term outlook is positive despite short-term uncertainties.

Invest Like the Best with David Einhorn - Founder of Greenlight Capital

This episode of Invest Like The Best interviews David Einhorn, the President of Greenlight Capital, a long-short hedge fund he founded in 1996 with AUM exceeding $10bn. David is renowned for his expertise in value investing and rigorous security analysis, including his famous shorts of Lehman Brothers and Green Mountain Coffee Roasters, as well as his 2013 precedent-setting lawsuit that compelled Apple to pay shareholders with preferred perpetual stock. We have broken the conversation down into five key topics that are well-explained and of the greatest relevance to our audience.

1. The Transition from Intrinsic Worth to Trading Value

The conversation opens with Patrick asking David about the optimal time to start a fund. David reflects on the favorable investing environment of 1996, where valuation debates were lively and worthwhile. He acknowledges that the market conditions have changed and that the emphasis in investing has shifted from assessing intrinsic worth to trading value. The participation of professionals in mid-cap and small-cap companies has also diminished, and earnings calls now predominantly involve sell-side analysts rather than buy-side investors.

2. The Criticality of the Macroeconomic Perspective

David discusses his non-momentum-driven investment style, where he increases stock purchases during market downturns and sells more stocks when the market rises. He emphasizes the importance of determining the true value of assets and challenges popular market trends and opinions, highlighting that this simple approach can often be the most effective. The conversation explores the "Jelly Donut Theory" of monetary policy, which states that the Fed detrimentally overprescribes policy instead of waiting for the effect of its decisions to play out in the economy. David explains that instead of further stimulating the economy, the continual reduction in rates becomes a drag on income. We discussed this theory in great depth in our April 14 newsletter; you can check that out here. David stresses the importance of macroeconomic and policy literacy for aspiring managers.

3. The Importance of Evolution

David explains that his approach to portfolio management continues to evolve with time. For example, the 2008 financial crisis taught him the importance of macro thinking. He has since adjusted the composition of his long portfolio to focus on companies that can generate returns based on their own merits, rather than relying on other investors to recognize their value. This shift implies potentially longer holding periods paired with a greater emphasis on the return of capital through dividends and buybacks. David also discusses a difficult period between 2015 and 2018 when trillions of dollars migrated from active management to index and passive strategies. This shift caused a divergence in his investment book, leading to significant losses (Greenlight lost 20% in 2015 and 34% in 2018, compared with a gain of 37% in 2022) and periods of self-doubt. He used techniques like factor analysis and technical analysis to examine his missteps but ultimately concluded that the evolving market environment was irreconcilable with his mostly stagnant investment approach.

David acknowledges the evolving nature of investing, especially in the current era with the availability and speed of information. He mentions that time arbitrage, once a significant factor in his strategy, has lost its relevance. Time arbitrage is what happens when a company’s mistake causes short-term-oriented investors to sell its stock, despite this mistake having a negligible impact on long-term valuation.

4. The Importance of Staying the Same

However, David also recognizes that some things are timeless, such as how he evaluates businesses and his perspective on shorts. He defines quality businesses as those that can sustain high returns on capital over the long term and explains that analyzing the real economics of a business is more important than relying solely on reported financial statements. David has long believed in concentrating his portfolio on companies where he has a high level of conviction. He is willing to take relatively larger positions than most investors when he has confidence in a particular investment opportunity. However, he does not believe in holding stocks forever and asserts the importance of selling when the value is no longer attractive.

Most of David’s most memorable plays are shorts (click here and here to see how he feels about Tesla), and he elaborates upon the role that shorting plays in his investment strategies. David sees short positions as a way to sell overvalued securities and provide a market hedge. He notes that shorting can be challenging, but it also presents incredible opportunities when the market corrects overvalued stocks.

5. Quick Notes on Sports, Poker, and Advice

David, who owns minority stakes in the New York Mets and the Milwaukee Bucks, sees sports franchises as unique and interesting assets, as well as a fun investing opportunity. He compares owning a sports team to owning a rare collectible, where the asset's value is determined by subjective factors like desirability and lived experiences. David also discusses his passion for poker (he finished 3rd in the World Series of Poker in 2012) and how the skillsets required for poker playing and investing are quite similar. Referring to both of these things as games of incomplete information and uncertainty, he highlights the importance of understanding your strengths and recognizing the pressure on opponents to gain an edge.

David advises young managers to prioritize exceptional and consistent performance, rather than trying to determine who are the “good” and “bad” investors. He also emphasizes the importance of being unproblematic to investors and avoiding the creation of new reasons to stick with a position after the original reasons that made you enter the position have disappeared.

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