PE Compression

Private Equity or PE as it is known, is in a bit of trouble. There is a decidedly nervous tone coming from analysts and investors about the previously impervious and ever rising valuations afforded to private companies, especially in the technology sector. But I saw this bubble coming a long time ago.

In the 90s, while building a business on the back of strong public equity markets, I had a front row seat to the golden era of the active public market investor. Pension funds in the 1990s were happy to pour money into stock markets in Canada, despite creating a home country bias. Even after relaxation of Foreign Property limits in the early 90's, they continued to allocate a disproportionate amount of their capital to the asset class.

The '08 crisis marked the death knell of that blissful world.

Back then there was already a dwindling number of good quality companies in Canada, especially if one wanted to reduce downside exposure to commodity prices. When the global financial crisis created an economic contraction, the specific risks of the resource rich Canadian equity market quickly became its achilles heel. Pensions started to exit stage left.

Volatility quickly became the new buzzword for asset management. And with the gut wrenching plunge of 2008, there was plenty of volatility to go around.

The complete disruption of normal price discovery in that crashing market meant big trouble for pension funds. Being 'marked-to-market' caused administrators to rethink their previously complacent views on Canadian public equities. The 'risk adjusted' returns offered by a burgeoning asset class - Private Equity - became an instant no-brainer.

Not only were private companies providing better growth opportunities, they were cheaper and easier to run. No worrisome public market regulations, no pesky activist shareholders, and no nosey analysts. Most attractively, they had no exposure to the huge valuation drawdowns public equities suffer in a market crash.

And when the time was right, you could sell the company to a growth starved publicly listed competitor or, even better, go pubic through an IPO. In so doing, PE investors could arbitrage the valuation differences between public and private equities to their advantage.

It seemed like an easy bet for pension fund administrators to make. So they piled in. And piled in, ... and in.

And it is still ongoing. In 2018, Canada's PE market saw 345 transactions valued at $37.2B. Led by the biggest funds, such as CPPIB and the Ontario Teachers' Pension Plan, new purpose-built investment arms were staffed up, and are still throwing huge sums at the asset class. Jamming so much money into the sector at a rapid pace has created a problem - the judicious deployment of that capital into the dwindling number of opportunities.

And now a new problem has surfaced, especially in the hyperactive technology sector. Overvaluation is now a systemic risk to private equity.

I once said that pension funds, by rushing into private equity, simply exchanged one risk for another. They were replacing volatility risk with valuation risk. Especially recently, as the few remaining large cap investments had become picked over. We all know that low discount rates, supported by easy monetary policy from central banks desperate to avoid another '08, have inflated multiples, most notably in private equity and real estate. Now the cheapest equities are to be found in the public markets, especially in industrials, financials and commodities.

The fable of the unicorn has been 'made real' in Silicon Valley. In the wake of the rise of mega-cap tech stocks like Amazon - a stock without any earnings - valuation became an art rather than a science. Revenue based valuation models eagerly adopted in the super-heated private equity tech sector. Now the reality checks are coming fast and furious. Recently, many highly anticipated IPOs have face-planted on their first day of trading.

Darlings like Uber, Slack, and Dropbox are well below their IPO prices. Today's debacle-du-jour is WeWork, a previous PE fav that has seen its share of governance related problems. Once valued at $47B in a funding from the aggressive conglomerate Sofbank, the proposed offering has been pulled even at the rumored valuation of $12B. Cue the mark downs.

And like a public market crash, private equity valuations are about to step-function lower, with no chance of getting out.

So, like the fabled unicorn, the 'free lunch' of private equity's promise of risk-less return has turned out to be a fairy tale after all. But I could have told you that.

Risk Model: 1/5 - Risk Off

Although last week saw a recovery in risk appetite due to improved sentiment on the U.S. China trade front, the attack on Saudi oil facilities quick negated that bullish surge. Encouragingly yesterday's muted reaction, combined with sober second thoughts from investors, has stabilized the market, albeit at somewhat elevated levels. The RSI of the XIU is 67 and it sits at 6% above the 200 DMA.

Copper/Gold put on a brave showing last week, rising above the 50 DMA, but the Saudi crisis quickly snuffed out the positive signal. It is lower this morning as well.

AAII bearishness retreated 8 points to near the historical average. The 3Mo VIX briefly signaled "risk-on" before bouncing higher in yesterday's mini panic. Thursday's reading may see a reflexive pull-back in bullishness given the escalation in Mid-East tensions.

Overall, the Model is on the cusp of a bullish configuration, especially if the reasoned approach adopted by the U.S. Administration to the provocations in the Saudi oilfields continues and investors are able to re-focus on the FED and the trade negotiations.

I would really need to see a recovery in global PMI readings before really committing to the equity bull case. Less bad is good enough in that regard, given the underperformance of cyclical equities. The market showed signs of broadening out last week, but it is too soon to call the cyclical turn given the data.

China is the key. Recent moves towards stimulus there have been thwarted by trade weakness. Both Xi and Trump are itching to get a deal but handicapping the outcome of two such unpredictable players is impossible.