Our view on 2019

What’s up buddy?

At the beginning of 2018, the VIX, an instrument which tracks the volatility of the S&P500, surged dramatically showing a comeback of fear among investors (Figure 1) following a period of extreme calm started after the financial crisis.

Figure 1: Higher VIX since February 2018

Figure 1

Source: Bloomberg

February’s spike in volatility led to further speculations about a coming correction or bear market as the end of the bull market started in 2009. Through 2018, we saw an increasing number of headlines on the coming bear market but, on the contrary, the main US equity indices kept reaching new highs without giving any signal of a downturn. However, during the week starting on October 8, the main US equity indices fell raising concerns about the beginning of a correction. On October 10, the S&P 500 swept 4% from its all-time high with the 60% of the stocks composing the index down >10% from the 52-week high, therefore in correction’s territory. Over 130 components fell at least 20%, level at which a bear market is recognised. Why did that happen?

We believe that the main drivers of the market downturn were:

  • The tightening monetary policy in the US and expectations on the ECB’s interest rates hikes starting from mid-2019;
  • Rise in fixed income products’ yield shifting capital allocation from stocks to less-risky assets (e.g. bonds);
  • Slowing inflation around the globe giving signal of a slowdown of the global economy;
  • Emerging markets’ downturn due to political instability (e.g. Venezuela) and higher oil price (e.g. India);
  • A stronger dollar causing weaker currencies around the world, especially in emerging markets;
  • Concerns over the trade war between USA and China and other political crises fuelling uncertainty in financial markets (e.g. Italy, Venezuela, Turkey, Iran);
  • Higher oil price increasing companies’ expenditures hence lowering margins;

On top of these drivers, on October 9, the IMF lowered its guidance on 2018 global economy growth to 3.7%, down 0.2% from April estimates. We believe that the combination of these factors together with the negative sentiment fuelled by the newsflow, triggered last week investors’ sell-off which led the main US indices down, as observable in Figure 2.

Figure 2: S&P 500 (white), NASDAQ 100 (green) and Dow Jones (orange) LTM %change

Figure 2

Source : Bloomberg

So, given the current situation, what should you expect for 2019?

Main topics

We believe that 2019 will be a turning-point year for investors with the main focus being on the following topics:

  1. Monetary policy
  2. Inflation
  3. Trade war
  4. Oil price

Monetary policy

After the beginning of the latest financial crisis, central banks pumped liquidity into financial markets and lowered interest rates in order to sustain the real economy suffering from a troubled financial system. The Asset Purchase Program (APP), also known as Quantitative Easing, was first started by the Federal Reserve (FED) in November 2008 and officially ended in January 2014. However, the FED waited until the end of 2015 to hike interest rates when it brought the US FED Funds Rate from the historical low of 0.25% to 0.50%. In September 2018, Jerome Powell announced the third interest hike in 2018 bringing the US central bank’s benchmark rate to the range of 2.00-2.25% (Figure 3).

Figure 3: Increasing US Funds Rate starting from the end of 2015

Figure 3

Source : Federal Reserve

The comeback of higher interest rates was triggered by the concerns around rising inflation and a potential overheating of the American economy. However, apart from making financing more expensive, the tightening monetary policy impacted the bond market, particularly increasing the 2-year US treasury bill’s yield to 2.85% from the 1.92% at the beginning of 2018 (Figure 4).

 Figure 4: 2-year US yield curve rose 48% YTD

Figure 4

Source : Bloomberg

As a rule of thumb, when the yield of government bonds surges, more risk-adverse investors shift their money from stocks to bonds as they can earn a decent return carrying the risk-free US Treasury bill. This shift of capitals from shares to fixed-income products generated a selling pressure on the stock market contributing to the above-shown downturn of the main US equity indices (S&P500, Dow Jones, NASDAQ). Looking ahead, we see the shift in capital allocation likely to continue as bonds’ yields increase due to the execution of the planned interest rates hikes announced by the FED. We see Powell’s schedule to be respected with 1 more hike in 2018, 2 in 2019 and 1 in 2020, leading the US FED Funds Rate to a potential 3.00-3.25% interest rate by the end of 2020 vs 40-year average of 5.72%. On top of that, the European Central Bank (ECB) announced the end of its APP to come in by the end of 2018 and consensus expects a first interest rates hike coming in in the second half of 2019. Albeit the political tension coming from Italy, we are aligned with consensus and believe that the ECB is set to hike the current -0.25% reference rate starting from mid-2019. An increase in European interest rates is likely to fuel the shift effect, leading to further sell-offs in the European stock market.

Inflation

US economy seems to be on the verge of the cool-off. Annual inflation showed a slowdown to 2.3% in September 2018, down from the 2.7% in August (Figure 5) and a miss vs expectations at 2.4%. It is the lowest rate since February and likely to be attributable to a sharp slowdown in gas prices. Since 1914, inflation averaged 3.27% reaching the high of 23.70% in June 1920 and the low of -15.80% in the same period one year later.

Figure 5: US inflation rate evolution since the beginning of 2018

Figure 5

Source : US Bureau of Labor Statistics

On October 15, US Commerce Department released data on US retail sales showing almost-flat growth with motor vehicle spending being offset by the biggest drop in spending at restaurants and bars in nearly two years. Retail sales rose 0.1% mom, 0.5% below expectations but up 4.7% yoy. Consumer spending accounts for more than two thirds of US economic activity. Despite historical low unemployment rate at 3.7% in September 2018 and 3Q18 expected 3.5% annualized growth in consumer spending, we see a slowdown in US macroeconomic data in 2019 and 3Q18 US GDP growth around 3.00%, down 1.2% from 2Q18. Adding to this, we see Trump’s rhetoric against the FED supported by investors’ that are losing confidence in Jerome Powell. JP Morgan recently published a report showing that the market reacted negatively to all the speeches given by Powell since the beginning of his mandate, quantifying the effect of his words in a US$1.5tn wiping away effect. This shows that investors are concerned about the speed at which the FED is executing its hiking plan as the expectations on US inflation are slowing down (Figure 6) putting investors on a wake-up call.

Figure 6: US annual inflation rate down in 2019-23E

Figure 6

Source : Statista.com

Trade War

On July 6 of this year, the US imposed 25% tariffs on US$34bn of imported Chinese goods in the beginning of what escalated to a proper trade war between China and US. On September 24, Trump’s administration imposed 10% more tariffs on US$200bn Chinese goods and China retaliated on US$60bn of US goods.

In this scenario, investors were scared of the potential effects that the neo-protectionist policies might have on their portfolio. In order to get a sense of how the trade war impacts companies, we looked at the luxury goods industry. Chinese authorities are implementing strict controls on travellers with the objective to look after imports over the duty-free allowance of CNY 5,000  (US$730). Chinese customers represent c.40% of the revenues for brands such as Louis Vuitton (LVMH) and Gucci (KERING) and a drop in purchases from Chinese customers would have a significant negative impact on the top-line of luxury brands. No wonder why on October 10, LVMH plunged 7.14% despite the company published strong results. We believe that investors reacted to the sentence of the head of Investors Relations at LVMH, Chris Holly, stating that the company is “subject to important risks and uncertainties that could cause actual results to differ materially” from previous forecasts. The entire luxury goods industry lost ground since the beginning of October, showing a more marked drop than other industries (Figure 7).

Figure 7: MSCI luxury good index (orange) down more than MSCI Technology (white) and MSCI Emerging Market (blue) since the beginning of October.

Figure 7

Source : Bloomberg

The example of the luxury industry gives a general understanding on how the trade war is already impacting equities and gives also a taste of the potential consequences that further escalations might have on the global stock market. We see the tensions between China and US to continue through 2019 leading to more industries being negatively impacted and a downward pressure on the global equity market.

Oil price

In October 2018, Brent oil – the main benchmark for oil price – was up 50% from the same period last year, reaching US$85.16 per barrel on October 9.

Figure 8: Brent spot price rose 50% since October 2017

Figure 8

Source : YCharts

The spike in oil price was mainly driven by the sanction imposed by the US government on Iran that lowered the OPEC’s member oil production to 3.4mbd (million barrels per day), down c.400,000 bpd from August 2018. Oil price is very sensitive to changes in supply/demand shifts and such a drop in supply makes oil scarcer hence increasing its value, therefore price, in the market. Higher oil price means rising energy costs for companies which will have to deal with increasing expenditures to keep the business going. This puts companies’ margins under pressure and translates into lower expected earnings per share (EPS). Therefore, investors see their expectations on dividends per share – computed as portion of EPS – decreasing and the equities’ bottom line shrinking. We see the oil price continue to rise in 4Q18 on the widening of supply/demand gap due to the uncertainty coming from Saudi capacity to cover the Iranian production wiped away by US sanction.  Also, we think it is worth to keep an eye on the development of the latest scandal on the US-based journalist disappeared in the Saudi consulate in Turkey since potential sanctions on Saudi Arabia from western countries would put further upward pressure on the oil price.

Food for thought

The last two weeks were characterized by the sell-off, but also by the US investment banks’ 3Q earnings releases. In the 3rd quarter of 2018, US banking sector’s results were overall positive with an improvement of the Net Interest Margin (NIM) – difference between interest income and interest expenses – thanks to the rising interest rates environment in the US. However, the IB – Global Markets divisions did not show much improvement. Indeed, results from the Sales & Trading departments of the biggest US investment banks (e.g. JP Morgan, Goldman Sachs and Morgan Stanley) delivered an overall performance below expectations. Therefore, one might draw the conclusion that investors are not exchanging their stocks for other financial products at higher frequency than last year, otherwise the level of fees should have been higher. Indeed, it seems that investors are selling their holdings without replacing those with other financial products, lowering the trade volumes hence commissions for the IB trading floors. From this perspective, one might argue that investors are taking out money from the market and building their cash piles in order to prepare for the worst-case scenario. As a corroborating factor of this thesis, BlackRock, the world biggest asset manager, had inflows below expectations in the last quarter showing a lowering investors’ appetite to put money in financial markets rather than under their mattress.

We believe that financial markets are impacted by a collection of reasons which go beyond the “Main topics” illustrated in this report. We are convinced that psychological, irrational and behavioral variables drive the market on daily basis together with financial, rational and economic factors. Therefore, we urge the reader to explore as many alternative explanations as possible when looking for reasons to justify markets’ moves.

Authors: Alessandro Sicilia, Lorenzo Bracco

The website and the information contained herein is not intended to be a source of advice or credit analysis with respect to the material presented, and the information and/or documents contained in this website do not constitute investment advice.

 

 

The Retaliation of Tech

Long we have been used to tech stocks trading at price multiples (price/earnings) at more than the industry standard has been comfortable with for decades. Benjamin Graham’s ideal PE is between 10 and 15 dollars. The Dow Industrial is trading at 25 PE, the S&P 500 is trading at 25 PE. If you thought that the Dow and the S&P 500 are overvalued by Graham’s standards, here’s a look at the tech industry valuations. Amazons PE is trading at 316, Netflix is trading at 206 PE, Dropbox has a negative PE. However, what was evident this past two weeks is that these tech stocks are more correlated than initially thought. When one tech stock sneezes, the entire market catches a cold.

Facebook has fallen 14% since 16 March when the news of privacy breach by Cambridge Analytica has spread. This caused Apple to fall more than 5%, Alphabet and Amazon have fallen more than 8%, and last but not least Twitter fell more than 19%.

However, one knows that a cold eventually ends, and with these company’s being sugar-coated with net margins of more than 20%, and growth potential, innovation and barriers to entry, it is important to keep watch for those companies. They are more likely than not that they are trading at a discount. Most of these tech companies have very strong balance sheets. This means they are relatively low leveraged. A hawkish fed of increasing interest rates has lesser of an effect on their valuation extended to the end of 2018.

However, as a kid knows exactly when to catch an ice cream truck, a good trader knows when to enter a stock. Technical analysis 101 serves a good purpose. Many mistakes made by students these days are getting excited very fast, being scared to fast, and not admitting one’s own mistake like a toddler refusing to get out of a car.

As long as markets are trading above 50-day moving average, the trader should be thinking “buy the dip”, many do the mistake of directly entering the trade once the stock price has fallen, however the truth is to better forgo some profit for a safety margin to allow one’s self to be confident that the stock is actually reverting. The 100-day moving average, this line provides the support between the 50 days and 200 days. If it does not hold support, there is a high probability that the 200-day moving average is the next stop, this is the deeper pullback in bull markets. 200-day moving average, this is an indicator telling you which side a trader should be one, either a bull or a bear market.

It is important to know that moving averages are not the Holy Grail of trading they are tools to help the trader capture a trend in their own time frame.

The point is will tech stocks retaliate and gain back valuation and return to their highs? Or will they descend even further? Either way, liquidate and hold 100% cash and wait and watch for those moving averages, because at this level they have attractive risk/reward ratio.

 

Author:

Bassem Mneimne

2018 EU-US Outlook: Where do we come from? What are we? Where are we going?

As the first quarter of the year is headed to the end and new challenges lay ahead for international financial markets, frame the actual situation is necessary to adapt to future changes.

2017 has been a record year both in terms of returns and volatility. Looking at historic data, seems obvious the past year represents an outstanding exception, may have the markets gone too exuberant? Economic and business data do not suggest so, with results exceeding expectations consistently.

 

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European Union: Renaissance

The year that just ended has proven the comeback of growth in the economies in Europe. The expansion in GDP and the steady decline in unemployment from the record level of 2011 has spread to Mediterranean countries and gathers speed. France, Spain and Italy have inverted their road joining Germany and northern countries in what can be compared to a renaissance of European Economy.

 

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As over 62% of EU countries’ total trade is done with other EU countries, the interdependency across EU economies has risen to levels which make necessary a harmonized growth to attain lasting results. Moreover, the strong reliance on exports, as testified by the fall in imports between 2012 and 2016 while exports grew in that period, has proven to be beneficial given the harmonized global growth. The EU accounts for 15% of global imports and exports approximately, making it the second world player and a necessary participant to global expansion. Which comes first, global growth or European expansion? The answer is irrelevant, as they influence and reinforce each other in a benign loop. The high levels of unemployment from which Europe started the recovery in 2012 leave space for further expansion, accompanied by low inflation rates which are consistent with an early stage recovery.

 

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Fiscal and monetary policies do not represent a threat, at least now. Governments around Europe share similar electoral programmes centred on the reduction of fiscal pressure and the enhancement of investments. The policy makers at ECB do not want to break the toy by acting too fast deleveraging their balance sheet, but the market is anticipating the end of QE and the beginning of the tightening cycle by end of 2018, beginning of 2019. Low interest rates are here to stay as Mario Draghi said, so the extremely favourable economic environment is going to support Equities through the year. The effects of improved stability can be seen inside Europe, with outstanding levels of consumer and business confidence, and outside Europe, with the Euro-Dollar Exchange Rate moving consistently with the strengthening of European Economies. The strengthening cycle of Euro started in 2017 will continue with the economic recovery, until Euro strength weights too much on exports. At least in the foreseeable future, this is not the case.

 

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Attractive valuations in European Equity offer long term opportunity for investors looking to take advantage of the economic environment. On the other hand, the extreme intervention of ECB in the Bond Market has created distortions in prices with risks skewed to the downside. This means that investors will be exposed to volatility, both in Equity and Debt Markets, once the normalization of interest rates begins in the following years.

 

United Kingdom: Uncertainty

A big question mark is represented by the United Kingdom: after the Brexit the outlook for UK economy has darkened leaving big gaps of uncertainty. Those gaps will be filled only after the conclusion of the negotiations with EU representatives with the deadline to negotiations fixed in October 2018. The IMF has already cut economic growth forecast for UK, expecting 2018 growth of 1.6%, down from previously forecasted 1.7%, followed by a further slowdown next year to 1.5%. The effects of uncertainty cited by Christine Lagarde, IMF Chief, are the delay in investments and the loss in spending power, caused by rising inflation, falling pound and stagnant wages.

 

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As a result, the UK will live the global expansion only vicariously losing relative strength and power in respect to other countries which offer better opportunities. On the other hand, the UK government will have to counterbalance the possible losses in the financial industry, approximately high net worth 100.000 jobs in the City with cascade effects on housing market, leisure industry and most importantly on tax revenue. The possibilities of actions range from a tax cut to a more generic business friendly environment, with Equities resulting as the most beneficiaries of the situation. Government bonds on the other hand are not as attractive, given the deficit that the UK government will incur to support fiscal policies. The uncertainty already weighting on the Pound will continue until businesses will have clear investment plans to adapt to the changing environment and markets will have enough information to take positions.

 

United States: Goldilocks

The expansionary cycle started in the US after the Great Financial Crisis does not seem to have stopped, as testified by the healthy 2.3% annual GDP growth for 2017, the steady decline in unemployment rate to 4.1% and the inflation rate of 2.1%.

 

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These are numbers of a country which have abandoned early stages of recovery and has entered the late stage cycle of economic expansion. In this environment fiscal and monetary policies diverge. The Federal Reserve has started the unwind of monetary policies in Q4 2017, by deleveraging the balance sheet from the record level of $4.5 trillion at a rate of $50 billion per month targeting a drop below $3 trillion by 2020. Moreover, the FED plans three rate hikes for 2018 as the normalization process continues, but the threat of inflation picking up at wages level is creating questions whether the FED is already behind the curve. Given the 2% inflation rate target, the FED may be forced to accelerate the hikes before expected from the market, causing turbulence to the new chair Jerome Powell.

 

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In this context, the Tax Plan approved at the beginning of the year by the Congress represents the fiscal lever to counterbalance the monetary contraction. Cutting the corporate tax rate to 15%, President Trump aims to stimulate the economy enhancing job creation, wage growth and investments. The slash of the repatriation tax rate on corporate cash held overseas, from 35% to 10%, is the second major incentive for investments in the country. With $2.5 trillion in cash held by US-owned corporations overseas, it is rational to expect a big portion of it to be reinvested in the US in the form of dividends, buybacks and M&A operations. As the economy is moving closer to full employment, the benefits of fiscal stimulus will likely be constrained because the economy is already operating at near full capacity. Nevertheless, GDP growth is expected to reach 2.5 percent in 2018 and then to moderate to an average of 2.1 percent in 2019-20. US listed companies will see the benefits of the Tax Plan on their balance sheets starting from 2018. According to the most recent estimates by UBS analysts, S&P500 companies will post an increase in earnings of 18% for 2018: nearly half of it, 8.5%, will come from pretax income growth, while the tax cuts for corporations, M&A and buybacks will provide a 9.7% growth.

How much of this positive outlook is already priced in by the market? The S&P500 delivered a 21.7% return in 2017, with no negative months across the year and extremely low levels of volatility, while the first quarter of 2018 has been characterized by spikes in volatility and dispersed returns.

 

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Valuations look stretched here: the Price to Earnings Ratio is above 25 and the Cyclically Adjusted Price Earnings, which takes into account the adjustment for the average inflation from the previous 10 years, is around 32. This does not mean that the market is going to crash, but that returns in the future are expected to be lower as the market is already pricing them in the valuations. The US market has historically been more expensive than the global markets, as it offers both the biggest companies and the highest diversification by sectors. Moreover, the US are the first global superpower by GDP, GDP per capita and international influence, which means that they will always attract more investments and will sell at a higher premium than other countries.

 

Two major factors to further consider are the Dollar and the Government Bond yield. The 10 Year Bond yield is approaching 2.9%, the first time since 2014, as the market is pricing in the widening budget deficit coming from the Tax Reform and the $1.5 trillion spending of the Infrastructure Plan proposed by Trump in February 2018. The Yield curve, represented by the difference between 10Y and 2Y yields, is downward sloping and consistent with late stage cycle expansion, the Goldilocks period before the end of the expansionary cycle.

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The last factor to take into account is the Dollar. Uncle Ben’s currency has started a weakening cycle from the highs of 2017, providing support both to overseas earnings of US stocks and to the FED in reaching the inflation target. As the global economy strengthens, risk-off currencies like the Dollar and the Yen should weaken as capitals flow to riskier countries which provide higher returns.

 

 

 

Author:

Mario Stopponi

The return of megadeals: Blackstone buys Thomson Reuters’ data unit for $17bn

On 30.01.2018, Blackstone announced to buy a majority stake in the data business of Thomson Reuters, the world’s second largest financial information provider. It’s the private equity group’s biggest purchase since the financial crisis, pitting the firepower and network of Stephen Schwarzman, who oversees $387bn in Blackstone funds, against fellow billionaire and former New York mayor Michael Bloomberg, who dominates Wall Street’s financial information industry.

 

When Blackstone announced to buy a majority stake in Thomson Reuters’ data unit, there was a lot of excitement among investors, pushing Thomson Reuters’s share price to new highs at announcement date. The $17.3bn transaction is Blackstone’s largest deal by enterprise value since the firm’s $26bn buyout of Hilton Worldwide Holdings Inc, in 2007. Under the terms of the deal, Blackstone will acquire a 55% majority stake in Thomson Reuters’ financial and risk division, which will then be carved out into a new company, with Thomson Reuters owning the remainder. CPPIB(1) and GIC(2), will co-invest alongside Blackstone. According to the Financial Times, the deal will not include Thomson Reuters’ newsgathering operation or its businesses serving the legal, tax and accounting communities.

 

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The deal volume of $17bn consists of a $3bn equity investment from the Blackstone-led group and $14bn in debt and preferred equity. Bank of America Merrill Lynch, Citigroup and JPMorgan Chase will provide debt financing for the deal, most likely including leveraged loans and high-yield bonds. Canson Capital Partners, Bank of America, Citigroup and JPMorgan were financial advisers to the Blackstone-led consortium, whereas Guggenheim Securities, TD Securities and Centerview Partners advised the sell-side.

The deal will make the Blackstone-led entity the major competitor of the financial information industries’ global market leader, Bloomberg. Blackstone sees attractive growth in the Thomson Reuters unit’s data feed, its foreign exchange and treasury trading platforms, as well as its risk and compliance business, according to industry experts. In addition, the division would also be able to improve operations more quickly than a private company, highly critical in a turn-around.

The market for financial data and information is only weakly fragmented with Bloomberg and Thomson Reuters accounting for c. 56% of total revenues in 2016. In 2017, global spending on information/analysis increased by 3.6% to $28.5bn, for the largest YoY growth since 2011. When looking at the historic development of the market, Thomson Reuters has been the leading player ahead of Bloomberg until 2011 with regards to market share. Since then, Bloomberg has largely evolved as the dominant player in the financial information market and successfully defended its strong position. However, with increasing competition from new players such as Goldman Sachs-backed company Symphony, the market could undertake a major re-organization and threaten Bloomberg’s dominant position, which offers significant growth opportunities for the new company.

The market reacted with a 9.5% increase in Thomson Reuters’ stock price, immediately after the acquisition plans were published, whereas the share price of Blackstone fell by 2% due to increased uncertainty among investors. A carve-out by a private equity firm could lead to a turnaround that Thomson would have struggled to achieve on its own ague analysts in favor of the deal. However, there are also concerns with regard to the feasibility of the turnaround. According to Bloomberg, there is a plateau problem regarding the earnings of the unit. To achieve private equity-style returns, Blackstone will need to boost the unit’s average earnings, which are flat around $1.6bn since 2012, a task that has proved difficult for Thomson Reuters in the past. Finally, the question remains whether a deal of this size is an outlier, or the start of a new wave of megadeals in the private equity industry to deploy record sums of dry powder. “There is undoubtedly a lot of dry powder in the market at the moment,” said Andrew Adams, chief executive officer at Quayle Munro, a U.K.-based M&A advisory firm.

 

Thomson Reuters Corporation is a Canadian media and information firm with revenues of c. $11bn in 2016. As of 2018, they employ around 45,000 people across the four divisions, financial & risk, Reuters news, legal and tax & accounting. In 2018, the financial & risk division accounted for over half of the company’s revenue.

The Blackstone Group L.P. is an American multinational private equity, alternative asset management and financial services firm based in New York City. As the largest alternative investment firm in the world. Blackstone specializes in private equity, credit and hedge fund investment strategies. As of December 31, 2017, Blackstone had $434bn in assets under management.

 

Sources:

For Illustration 1: Thompson Reuters Revenue by Segment. Retrieved from: The Wallstreet Journal (2018): https://www.wsj.com/articles/thomson-reuters-chairman-criticized-its-17-billion-deal-with-blackstone-1518692400

Spotify goes public, not through an IPO

Spotify will go public before the end of the first half of 2018 and has already filed confidentially with U.S. regulators for an initial public offering. Morgan Stanley, Goldman Sachs and Allen & Co to advise on the listing, acting as commission brokers that will only help selling the shares.

Spotify, the privately held Swedish music company, last valued at $20 billion,  will not be selling its shares and raise any capital through a standard IPO process but it will be the first large company to go public via an unusual direct listing on the NYSE.

Spotify is the biggest global music streaming service with 70 million paying subscribers as of January 2018 (compared with Apple Music’s 30 million), over 140 million active users worldwide and 30 million songs available to stream straight from the internet.

While Spotify’s losses are mounting – the company experienced net losses over the last 5 years and saw losses more than double in 2016 to 556.7 million euros – its revenues increased by 52.1 percent in 2016 and by 39% in 2017.

One of the reasons behind this unusual choice might be found in that the company had raised $1bn (£740m) in a debt deal with private equity companies in 2016. The deal provided that the debt interest rate would increase by 1% every half of a year until the company went public.

Moreover, Spotify’s listing would benefit not only its CEO Daniel Ek who controls 25% of the company and Martin Lorentzon, co-founder and director and former chairman, owning 13% of the company, but also Sony Music Entertainment International, Technology Crossover Ventures, Investor Tiger Global and Tencent which are the major investors of Spotify.

Company founders will retain control of the company by holding onto a separate class of shares, so-called dual-class, with enhanced voting power. The “dual-share” structure, employed previously also by Facebook and Alphabet, is not the only feature that sets this listing apart.

 

What is unusual about this

First, when a company decides to go public it does so by issuing new shares and increasing capital. However, Spotify decided not to go for the traditional route and thanks to the direct listing the private company will sell their shares on the market by bypassing the underwriting process by directly selling shares to investors at a price determined by the company without any help from investment banks.

Second, direct listings have occurred mostly in biotech and life sciences and have been limited to small-cap companies, Ovascience (market cap: $55 million) and BioLine Rx (market cap: $83 million) being two examples.

Third, when a company decides to go public it needs to register with exchanges, which are usually NASDAQ and the OTC market.  However, Spotify has asked NYSE to change rules, and for the first time it will go public via a direct listing on the NYSE.

 

The Process

The process for going public is very similar to the IPO. In fact, the business presentation, due diligence, prospectus preparation, and forms required are the same as for an IPO but with an exception. What is different is that a direct listing does not require the 2 week roadshow.

You will ask, is a roadshow really needed? Usually it is carried out in order to setting up meetings and interviews, so that the investment bank will increase demand. However, being Spotify a large company, with an established brand and a knowledgeable customer base, a roadshow is not really needed.

Direct listings can be compared to the opening of a shop and hoping people will just drop by. The store is open, but you do not have anyone marketing or setting up meetings.” says Kathleen Smith. Private shares will become legally tradable and therefore whoever owns Spotify stock will have the chance to offer it on the public market and slowly Spotify’s stock will begin trading like any stock.

However, since there will be no agreed ‘starting’ price it is unclear what will happen at  start of trading if the demand will be higher than the supply, hence we could see huge volatility (more than in an underwritten IPO) of Spotify’s share price.

 

Advantages of a direct listing

A direct listing will leave less money on the table as people will not sell their shares at a lower price. Moreover, since no new share will be issued there will be no dilution for existing shareholders.

In addition, investors can sell their shares more quickly as there is no lock-up period that prevents insiders from selling shares in the months following a listing. Finally, a direct listing requires no underwriters and  therefore is cheaper because of no fees.

To sum up, in three words,  direct listing is faster, easier, cheaper.

 

However, there are some disadvantages

Since there is theoretically no need for an investment bank, the company will not benefit from a professional support from investment banks (especially in terms of demand generation and liquidity support). Moreover, it will not have buffers against volatility (especially on the first day where volatility is usually high), and will not take advantage of presentation support from advisors (important for small to medium companies). In addition, its price will purely be determined by demand and supply and Spotify will not have any control over it.

Lastly, the company will be less likely to have long term investors, usually gained during the roadshow process.

 

Conclusion

Spotify’s unusual way of going public could change not only the way that large technology companies go public in the future especially those who do not need capital and would like to go public like Uber and Airbnb but could also impact investment banks’ business model as they would not be able to collect many underwriting fees. However, if Spotify, falls below the valued amount, it would probably not like a successful roadmap to follow.

Are We on the Verge of a Trade War?

Many of us have been asking ourselves this question after President Trump announced his intention to impose 25% and 10% tariffs on steel and aluminium imports, respectively. Trump’s announcement might be challenging the GATT (General Agreement on Tariffs and Trade) which despite evolving throughout time, have remained the WTO’s foundation since its establishment after World War II.

Globalisation has triggered global economic expansion and development, leading to substantial real income growth. However, developed countries’ middle class has not experienced such an increase on their real income. A decrease in their purchasing power has lead them to blame globalisation and free trade agreements for this.

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This sentiment has triggered an increase in protectionism, being Brexit and Trump’s election two illustrations of this anti-globalisation movement. Trump’s potential tariff imposition is therefore another protectionist measure founding his campaign’s slogan: “Make America great again”. Previous protectionist tariffs, such as those imposed by George W. Bush in 2002, resulted in a loss of 200,000 jobs. Will it be any different this time?

Despite affecting other countries, such as Canada or Mexico, in a more devastating way, when Trump talks trade, he talks China. Decreasing China’s record high trade surplus with the US is one of Trump’s main targets, which he has emphasized throughout his mandate.

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China, the EU and other countries have expressed their concern regarding steel and aluminium tariffs and have threatened to apply several countermeasures.

CHINA– China is one of the leading US export car markets as well as being one of the top tourist and technology-purchasing markets. Additionally, China holds over $1tn of US debt. Some likely countermeasures could be industry-specific, such as restricting automobile, semiconductor or agricultural imports from the US. Examples of firm-specific measures include restricting iPhone sales or substituting Boeing for Airbus aircrafts. Other counteractions might include discouraging travel to the US (more than 100 million Chinese people travel around the world every year) or limiting the number of Chinese students in the US. The Chinese Government, however, remains cautious in attempt to restrain a potential trade war.

CANADA– Canada would probably be Trump’s most sound victim if these tariffs are actually applied. Prime Minister Justin Trudeau classified them as “absolutely unacceptable” and expressed Canada’s intention to respond to them by targeting two symbolically-valuable industries: manufacturing and agriculture. Trump, however, announced that Canada and Mexico could be exempted from these tariffs if NAFTA were to be renegotiated.

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EU– The European Commission president, Jean-Claude Juncker announced that the EU’s will engage in a collective response with other countries affected by these measures. Additionally, Juncker expressed EU’s intention to prepare a list of potential retaliation tariffs which would most likely add up to almost $3 billion. These tariffs would target a list of products including clothing, cosmetics, motorbikes, boats, agricultural products and industrial products.

UK– Despite being the US one of the UK’s most important trade partners and even though a possible US-UK post-Brexit free trade deal had been rumoured, Theresa May has expressed her “deep concerns” regarding new tariffs and confirmed that “while the UK remains part of the European Union, any action would come as part of an EU-wide response.” [1]

According to the WTO, Mexico, Japan, Australia, India and South Korea are also “very concerned” with Trump’s potential tariffs and have announced their intentions to apply countermeasures.

 

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Despite easing trade war likelihood, the application of such tariffs would have a remarkable global impact if it escalated to a trade war. Some possible long-term consequences would include:

  • Global economic expansion slowdown triggered by decrease in global output
  • Gross job loss
  • Worldwide inflation driven by increase in product prices because of tariffs
  • Equity market sell-off driven by lower corporate earnings expectations
  • Decrease in risk appetite, increased demand for safe havens
  • FX fluctuations
  • US Tech sector decline

 

CONCLUSION –Imposing these tariffs on aluminium and steel may seem insignificant at first, however, this would most likely result in a series of retaliatory measures which would in the end lead to a trade war. “Protecting” these metals, mostly input goods, would have a negative impact on other aluminium and steel-consuming industries. Assuming no retaliatory measures are applied, negative consequences would still escalate to other countries, in a world where globalised supply-chain dependency is a reality. For a country that accounts for 13.9% of the world’s imports and 9.1% of the world’s exports a trade war definitely does not sound like the best solution.

 

Author

Carmen Álvarez Álvarez

 

Sources

Mifid II: what about the markets?

3rd of January 2018, while the markets started well their year and were keeping a bullish direction before the recent increase in volatility, something else started. Yes, it’s the new European Union Markets in Financial Instruments Directive known also as MiFID II.

Most people talked a lot about it during the last quarter of 2017 and were trying to understand the possible opportunities and threatens related to this topic. But first, let’s see what it is about.

 

The Directive

The aim of this big EU directive (more than 7000 pages) is to protect investors and make sure they receive “fair” deals when dealing with Fund and Asset Managers and so try to make Financial Institutions more transparent. This happens thanks to reports filled within 15 minutes from the transaction so that the regulators can spot abuses in all existing asset classes (Bonds, Stocks and Derivatives) and consequently become more diligent.

A major related change is for Bonds and Derivatives as they will not be any more phones involved in those processes, but everything will be done electronically. In this way, the EU wants to push back a lot of trades to public exchanges so that they can be monitored.

On the Equity side, EU was pushing for stricter limits regarding dark trading but at the last minute it was set back, probably to broaden this aspect, making still possible to trade more than 600 stocks on dark pools. The dark pools are basically private exchanges or forums for trading securities not accessible by the investing public. In those exchanges there is no transparency at all and are mainly used by institutional investors who do not wish to impact the markets. This is confirmed by Trista Keller’s (Bloomberg) statement which says: “For a lot of people MiFID II has still not happened, at list on the equity market”.

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With this little, simple and effective table published by Bloomberg, we can have an overview of the rules that the European regulator introduced and the result that should therefore arise.

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The implications

Let’s now look at the implications of this directive. First, different studies showed a decrease for Research inside banks, both in budgets and in people. Therefore, many professionals of the sector decided to leave earlier to create their own firm. This because an increasingly large number of leading asset managers already announced they will internalise the cost of research in their P&L instead of charging it separately to investors via Research Payment Accounts which are accounts exclusively created for the clients to put funds in to pay for research and directly managed by the financial institutions and banks. A McKinsey report estimated a 10-30% reduction in buy side’s external payment for research over the next three years and a S&P survey indicates that, asset managers’ EBIT may decline by 15%/ 30% because of the shift to P&L accounting for external research expenses.

From the following chart, the first impression is that big banks need a lot of information and their demand seems very fragmented. However, 20 banks account for 64%. Therefore, according to 80:20 Pareto’s rule, one can dominate the market by providing reports of Equity Research to a small number of big players.

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Moreover, the impressive decrease in European Research budgets both in terms of advisory and brokers, could lead to a big change in banks demand.

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Another big effect is on Sales&Trading which last year has seen a declining number of traders together with an introduction of electronic trading engineers. Indeed, specific data compiled by McKinsey on the Equity segment of the top 9 investment banks show the overall Sales&Trading headcount declined three times faster than Research since 2011. For example, Goldman Sachs’ US cash equity business moved from 600 traders in year 2000 to only 2 traders in 2016.

In fact, with MiFID II will cause lot of job loosing but at the same time many have been, are and will be created. For example, the number of job adverts on LinkedIn for MiFID-related roles has more than quadrupled in the last year in a sign of how companies have been trying to be well prepared for the far-reaching European regulation. Banks, asset managers, consultancy and law firms have all embarked on a hiring spree ahead of the introduction of the second instalment of the Markets in Financial Instruments Directive.

This is quite a revolution happening in banking which is also related to Fintech and Robo-advisory recent success among investors. Indeed, this disruptive companies are recently receiving large funding from high-profile investors and hiring new talents to take advantage of growth momentum.

 

Winners

Until now, MiFID II has created some advantages that benefited some players such as:

  • Pension funds and family offices will be advantaged as they will be more aware of the fees payed for researches and so increase their bargaining power. Regarding the price, also big money managers such as BlackRock and Vanguard Group will benefit.
  • Platforms in general will benefit from this directive and particularly in hedge funds where they will ease compliance and reduce again costs.
  • Individual investors will be more aware of the fees and this might lead to a big shift from funds to ETFs due to their lower cost. Indeed, they are forecasted to surge from 725 billion dollars to more than $1 trillion in next 1 to 3 years.
  • Big Investment Banks will be able to compete on prices for research eventually building a new revenues stream.

Losers

As any other piece of legislation, MiFID also created some “losers”:

  • Smaller companies with lower budgets will encounter higher prices for obtaining information and may charge higher expenses to clients which could cause a negative impact on business. The same goes for smaller investment banks and boutiques that cannot afford a war price on their research products.
  • Hedge funds will have to insert reports within 1 minute for the equity side and 15 for the fixed income products. This will probably impact their transaction volumes and costs in terms of time and money.
  • Research teams will shrink and so their effort higher or the output poorer. Are unexperienced investors ready to independently search for stocks without being able to rely on recommendations? Will they take the risk or miss the opportunity? What would happen to the relatively unknown small cap? Would the capital run towards big firms leaving the small ones illiquid? As trades would not be any more done over the phone but via platforms, who will now loose his voice and go to the doctor? And what about the already declining fixed phone business?

 

 

Authors

Lorenzo Bracco

Private Equity – Snapshot & Outlook

– In 2017, Private Equity markets continued to reach new record highs with regard to capital commitment, deal valuations and number of active investors. Competition for private investments increased dramatically, largely caused by traditional asset managers shifting significant proportions of their capital into private markets. With easy access to capital and increased competition for deals, Private Equity investors increasingly experience problems to effectively deploy their capital. However, the valuation rally is expected to continue in 2018, introducing new forms of investors, so-called megafunds. –

STATUS QUO – Private Equity markets are booming: Private asset managers raised a record sum of nearly $750 billion globally, extending a cycle that began eight years ago. In addition, less traditional investors such as pension funds or sovereign wealth funds increasingly engage in direct investments in private markets due to a lack of profitable investment opportunities in more traditional asset classes. With more capital available, the total deal volume rose by 14 percent to $1.3 trillion compared to the previous year, reaching almost its record high of $1.4 trillion from 2007. In contrast, deal count dropped for the second year in a row by 8 percent. As a result, the average deal size increased from $126 million in 2016 to $157 million in 2017, a 25 percent increase, mirroring the increased competition among investors.

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Furthermore, the Median EBITDA multiple for investments in 2017 exceeded 10x, displaying a significant increase from its previous all-time high of 9.2x in 2016. Despite record valuations, the number of exits fell for the third consecutive year, suggesting that investors believe in further value appreciation of their investments.

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High investment performance and superior yields for limited partners attracted new types of investors, ultimately resulting in greater capital commitments and fund size: The latter can be attributed to a large part to the rise of US buyout megafunds, private blind-pool capital vehicles with assets under management (AUM) above $5 billion. The prevailing wisdom has long been that the “law of large numbers” might put a cap on megafund returns, however average returns have outperformed returns of other fund sizes consistently during the last decade. The latter was not only a US phenomenon: The rise of US megafunds was nearly matched in Europe, where several firms successfully closed big new funds totaling $40 billion, and in Asia, where megafunds—previously close to nonexistent— contributed more than $20 billion of the $60 billion raised in 2017.

Besides buyout funds, it appears that other private asset classes constitute increasingly attractive investment opportunities for investors. First, private debt markets are more and more seen as a good alternative to banks and public debt, fueled by all-time low interest rates and investor demand for portfolio diversification. Second, real-estate gained popularity following collective rent rises in major cities. While investors have historically viewed Real Estate as a source of alpha, more and more are coming to see it rather as a source of income. In a world of compressing yields, relatively low-risk assets that produce annual returns of 5 to 7 percent, appeal to many investors. Finally, infrastructure investments remain an attractive alternative for investors. Since 2016, some of the largest general partners have raised record-breaking funds for traditional, brownfield infrastructure strategies.

CHALLENGES – Due to the continuous popularity of Private Equity as an investment vehicle, new challenges have emerged, pressuring the superior profitability of the industry. Higher number of sophisticated investors, ranging from pensions and endowments to family offices, decrease the likelihood for exclusive bidding. Hence, valuations continue to approach artificial highs, which makes it considerably more difficult to reach desired return multiples. This can be mainly attributed to thriving public markets, corporate strategic investors as well as the low-cost debt environment.

The public markets are hot despite some recent wobbles, which has been driving comparables’ valuations to new heights. Furthermore, the low-cost debt environment of the past decade encouraged strategic buyers to open their pocketbooks and quickly expand through acquisitions. In so doing, they are competing directly with Private Equity for deals and pushing multiples even higher. Another factor is the ongoing availability of cheap debt, which is driving up leverage levels for company acquisition, thereby increasing the risk for lenders in case of default. The mere unlimited rise in valuation manifests in fewer investments from general partners, zeroing in on targets where they can still earn an attractive IRR. However, what constitutes ‘attractive’ is undergoing revision, as many firms lower their hurdle rates in response to higher prices. Thus, investors sit on a whopping $1.8 trillion of dry powder in 2017. A continuation of this trend over the coming years would result in a vicious circle for general partners, forcing them to further reduce hurdle rates as well as to deploy capital in situations they otherwise would not.

 

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OUTLOOK – The next years will undoubtedly mark a decisive period for Private Equity as a mainstream asset class. Following the rise of megafunds, we expect to see assets to consolidate at the top of the league table, i.e. private market funds are beginning to concentrate into fewer hands. This trend will be supported by a growing number of co-investments between traditional Private Equity investors and new direct investors such as pension funds.

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In addition, funds will aim at bringing more structure and scale into their processes to cope with the changing market environment, innovation and unconventional investment horizons. For example, we currently experience first attempts of next-generation sourcing, which aims at improving sourcing with sophisticated analytics. Funds may be able to automatically match their sourcing activities with investment criteria and their respective perception of industry attractiveness. Besides, we expect to see investors increasingly engage in active management, as digital transformation processes open up new opportunities for value creation, which cannot be realized (at least in the holding period) without major involvement of the investor.

Due to uncertainty about future interest rates and valuation multiples, Private Equity investors will increasingly deviate from average exit periods: On one end, exit cycles for investments purchased at high multiples may decrease to as little as two years, as firms cash in on multiple growth early when they anticipate that multiples will decline. On the other end, Private Equity investors allocate theirs funds to private asset classes generally associated with longer holding periods (e.g. infrastructure, natural resources, and Real Estate) due to their high value creating potential.

In summary, Private Equity will remain one of the most sought-after assets classes experiencing further growth in both number of investors and average deal sizes. However, the future will show whether today’s high valuation levels are reasonable and enable superior exit returns.

 

Authors

Paul Theilig

Felix Schafer

 

Sources

  • McKinsey Global Private Markets Review (2018). The rise and rise of private markets.
  • Pitchbook (2017). European Private Equity Breakdown
  • Bain & Company (2017). Global Private Equity Report

Breakfast with: Federico Tenga, Bitcoin Entrepreneur and Co-Founder at Chainside

Breakfast with: Federico Tenga (alumnus MiM ESCP), Bitcoin Entrepreneur and Co-Founder at Chainside.

Federico is an early bitcoin adopter, co-founder at Chainside and consultant for blockchain implementations. In December 2014, he founded the Italian branch of the BEN (Blockchain Education Network) with the aim of spreading the network in the Italian Universities.

Q: First of all, I would like to thank you for taking part in this episode of the ESCP Finance Society’s “Breakfast with” agenda. How did it come to your mind to deepen your knowledge about Bitcoin in 2015? What did your classmates think about it at the time?

Actually the first time I learned about Bitcoin was in 2011, when I was still in high school, but even if I found the concept very interesting at the time I didn’t get passionate about it. Later, in 2013, I finally started studying it, trying to trade it and start with my first projects around Bitcoin. While at university I had many classmates that showed some interest in the topic, but just few decided to try to learn more about it or buy some coins.

Q: What is Chainside and what is your long-term plan?

Chainside’s goal is to make easier the interaction with the blockchain for enterprises, reducing technical barriers with a simple interface that abstracts the complexities of Bitcoin. Right now we are focused on bitcoin payment solutions for merchants, but since differently from some other competitors we built our own technology from scratch, we are able to enable new blockchain use cases according the customers demand. In the long-term, we aim to establish ourself as a leading company in the industry and facilitate the transition to a crypto-based economy.

 

Q: Why should a firm choose Bitcoin over fiat money? What are the advantages of the former over the latter?

Bitcoin presents multiple advantages, both for people using it as a medium of exchange and for those using it as store of value. A firm accepting Bitcoin payments can benefits from the absence of charge-back related frauds as the settlements of a Bitcoin transaction is some order of magnitude faster than any traditional payment system (just about 10 minutes). Moreover, thanks to its permission-less nature, Bitcoin makes possible financial interaction also with people who do not have access to traditional financial infrastructure, or people who care about their financial privacy and prefer to use a tool not controlled by any centralised entity, increasing the potential customers of a company. Bitcoin has also the advantage to be programmable money, making innovation and automation more effective.

On the other hand, enterprises looking for a superior store of value for them or for their customers will find in Bitcoin an asset with limited and deterministic supply backed by frozen energy, somewhat similar to gold but technically more advanced.

 

Q: Do you actually believe that Bitcoin is an expression of financial world’s democratization (given that 97% of Bitcoins is held by 4% of the addresses)?

I don’t think that the distribution of wealth is really related to financial democratization. Bitcoin is an expression of permission-less finance, meaning that anybody in the world can have access to advance financial tools without having to deal with the limitations imposed by local regulation. This means that under a financial perspective, people in developed countries won’t be as advantaged as they are today over people in developing countries with poor banking infrastructure.

 

Q: As of 4 February 2018, the number of existing cryptocurrencies is over 1,512 and still growing. Who will thrive in such a market in the long term and what is the competitive advantage of Bitcoin over the other cryptocurrencies?

Most of those cryptocurrencies out there are already to be considered dead, only few of them actually have a decent transaction volume. In general, I am expecting a consolidation in the coming years, if you think about that the purpose of money is to be the single intermediate good that everybody uses for trading, so with the exception of transition phases when better money substitutes inferior money, people will always converge on using a single currency. This means that there is no space for multiple cryptocurrency in the long term, and the market will converge on the best one, which at the moment seems to be Bitcoin as it has the more stable and battle tested technology and a stronger network effect. Some cryptos claim that their purpose is not to be a currency but something else (e.g. a world computer), so they are not in competition with Bitcoin, but the truth is that they still need a native currency to secure their blockchain, so they will suffer competition anyway.

 

Q: Do you think it is possible to apply financial theoretical concepts to Bitcoin and cryptocurrencies in general? For example, is it possible to identify the fundamentals of a crypto? If yes, please explain how.

There are fundamentals in crypto, as there is an utility that people consume while using cryptos. When you want to evaluate a cryptocurrency you have to ask yourself “do people have any benefit in using it” and “is it long term sustainable”, which also implies how scalability concerns are being addressed. Bitcoin has already proved to be a good store of value and a useful medium of exchange for a least some niches, and current protocol upgrade proposals create optimism about the future, while most other cryptos are in a phase where they still have to prove themselves to provide some kind of real value to the users and have long term sustainability.

 

Q: Different investors use different methods to analyse an asset before investing in it. Which method should an investor in Bitcoin use? And if you have ever invested in it, which one did you use?

I studied the technology and tried to see the potential and the limitations. I know it can be hard for people without a technical background to really understand how the technology works, but if you don’t make some effort to study it as much as you can, it becomes very easy to make very expensive mistakes when it comes to investment. Understanding the tech helps you to see what the long term trend can be, while for the short term I consider any kind of trading mostly gambling, so it can be fun but there is no much you can do to systematically outperform the market.

 

Q: Warren Buffett in an interview to CNBC said: ”I can say almost with certainty that cryptocurrencies will come to a bad end.” In your opinion, are we witnessing the burst of the bubble or a healthy correction?

I believe that corrections are a natural part of a price discovery process, so as an asset gains popularity it is to be expected to have both bull market and bear market phases. The fundamental value of the technology is growing with new protocol upgrades being proposed every week, so I consider the daily price fluctuation just a distraction.

 

Q: Last question, what is the most important piece of advice you can give to the ESCP students that would like to pursue a career in Fintech industry? What are the most important qualities to succeed?

You need to be willing to go out of your comfort zone and start studying stuff you know nothing about on your own, you can’t be successful in Fintech if you don’t know how the technology works under the woods. You also have to deal with the fact that the university cannot help you in any relevant way to be prepared for the industry, it is a fast changing environment and few people are knowledgeable about these topics, and they usually don’t teach in universities. The good news is that nowadays there is so much information freely available on the Internet, so  you can easily learn a lot alone, but it requires commitment and genuine interest. 

 

It has been a pleasure to host you at our “Coffee Break”. Thanks again for your time and patience, Mr. Tenga!

 

Author:
Andrea Simoni

Private Equity – The best asset-class of the last 25 years

Private Equity – What is it?

Private equity (PE) has gained a great amount of influence in today’s financial marketplace, but only few people actually understand the ins and outs of the industry.

This quick article (less than “360” seconds long!) breaks down the topic, discussing in brief (i) the different types of PE strategies; (ii) the main PE firms out there and (iii) the current momentum of the industry.

First things first. What is a PE firm?

To make an (extremely) long story short, PE Firms are essentially asset-management companies (AMC) advising, managing and investing investor’s money through registered investment vehicles called “funds”, each having a different investment scope. AMCs need to comprise skilled and trustworthy Investment Professionals able to raise capital and attract investors promising in exchange solid and constant returns.

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PE investments range from listed and non-listed companies to physical assets (i.e. real estate), offering returns much less correlated to indexes than the returns available in classic public market investment opportunities. However, the tradeoff is that these investments are illiquid (i.e. 3-7 years to generate attractive returns) and thus require longer investment periods.

PE Firms can invest in a wide mix of private investment strategies, with the mix varying greatly from firm to firm depending on the firm’s size, stated strategy, geographical scope, industry and transaction expertise. There are many different types and sizes of PE firms / Funds specialised in either a specific industry or a specific geography.

 

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7 PE strategies – The key elements

Here are the main PE strategies everyone should be aware of:Venture capital (VC) – startups and young companies / little to no track record of VC investments are made with the goal of generating outsized returns by identifying and investing in the most promising companies and profiting from a successful exit (the most desired being an IPO)

  • Growth capital – mature companies / proven business models / looking for capital to restructure their operations, enter new markets or finance an acquisition. Typically, these are minority investments in more mature companies than for a VC scope
  • Buyouts – mature companies / generating significant and steady cash flows. PE firms make buyout investments when they believe that they can extract value by holding and managing a company for a period of time and exiting the company after significant value has been created. This strategy typically involves debt (i.e. usually above 50% of the total acquisition value) to finance the acquisition, enabling the PE Firm to generate high returns while only risking a small amount of capital
  • Fund of Funds (FoF) – investments are made in PE funds rather than directly in the equity of companies. By investing in a fund of funds, investors are granted diversification and the ability to hedge their risk by investing in various fund strategies
  • Debt/Mezzanine – consists of both debt and equity financing to support a company’s Companies that take on mezzanine financing must have an established product and reputation in the industry, a history of profitability, and a viable expansion plan. A key reason of why a company may prefer mezzanine financing, is that it allows it to receive the capital injection needed for business without having to give up a lot of equity ownership
  • PE Real Estate – investing in ownership of real estate properties. The 3 common strategies are: (i) investments in low-risk / low-return assets with predictable cash flows requiring some form of value added element; (ii) medium-risk / medium-return investments involving the purchasing of properties to improve and sell at a gain; (iii) high-risk / high-return investments in properties requiring massive amounts of enhancements (i.e. investments in development, raw land, and mortgage notes)
  • Special situations & Distressed funds – target companies that need restructuring, turnaround, or are in any other unusual circumstances. Investments typically profit from a change in the company’s valuation as a result of the special situation. (i.e. company spin-off, tender offers, bankruptcy proceedings…). Besides PE Firms, Hedge Funds also implement this type of investment

 

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The main players – American legends vs. European firms

Henry Kravis (KKR), Steve Schwarzman (Blackstone), David Rubenstein (Carlyle) and Leon Black (Apollo). These four men run the world’s largest private-equity firms.

Billionaires all, they are at or well past the age when CEOs of public companies move on, either by choice or force. Apple, founded the same year as KKR (1976), has had seven bosses; Microsoft, founded the year before, has had three. On average, public companies replace their leaders once or twice a decade. In finance executives begin bowing out in their 40s, flush with wealth and drained by stress.

 

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One thing is clear, the fame of the big names in the industry resides in the US!                    But Private Equity is not just an American thing. The “Old Continent” defends itself well. The UK leads the table when it comes to PE, placing 7 Firms in the European Top 10.

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The current momentum – why does everyone want PE?

Last year was a massive year for private-equity fundraising, and there is little indication that the flow of money into the asset-class will wane any time soon. A staggering 48% of European investors plan to put more money into private equity this year, compared with 2% who plan to trim their allocation, according to a survey published in December by Coller Capital.

“As long as the demand from investors is there, we will see firms looking to raise bigger funds,” she said. “Some private-equity managers will try to raise as much as possible; others will try to remain more disciplined. Some managers, such as Vitruvian Partners and Partners Group, more than doubled their fund size last year.” – Britta Lindhorst, MD at HQ Capital

As of December 2017, there were 1,038 new private-equity funds (less in number but way bigger in size) in the market filled with $415bn of fresh capital (+6.5% vs 2016), compared to 1,324 funds seeking $390 billion a year earlier, according to Preqin. In brief, 2017 was another record-year for PE (i.e 7th year of consecutive growth), the tough times post 2009 financial crisis are long gone.

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Reasoning on why PE gained so much attention in the last decades, one thing pops up quite immediately bringing us back to the title of the article: Private Equity is simply the most profitable asset-class of the past 25 years!

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Authors

Massimiliano Marchisio

Nikita Kuzmich

Paul Theilig

Felix Schafer

 

Glossary

AMC = Also called General Partner “GP”, is a financial institution approved and supervised by the local authority, whose task it is to manage the fund.

Fund = a fund is a “bucket” filled with investors’ money and managed by the AMC. The amount of money collected can be used to invest into any type of asset

Investors = Also called Limited Partners “LP”, are banks, insurance companies, pension funds, family offices, corporations, governments, HNWI…

 

Suggested readings

Barbarians at the Gate: The Fall of RJR Nabisco – Bryan Burrough and John Helyar (1989)

 

Sources

  • The Economist
  • Cambridge Associates Private Equity Benchmark
  • Street of Walls
  • Private Equity News
  • Private Equity International
  • Financial Times
  • Preqin – Research Center
  • Macabacus – Finance