In Part 1 of this series, I explained my thought process about the direction of public markets. My contention is that our policy-makers have no choice but to run a policy of financial repression. Under this regime, the Federal Reserve allows inflation to remain elevated at say 3-5% and only intervenes if it thinks inflation will get out of control (as it did over the last year). It will then peg interest rates just under inflation. This gradually brings down the debt-to-GDP ratio over time hurting savers and buyers of Treasury bonds. Workers and debtors in turn will benefit.
While I think public markets are irrationally bullish, they have at least begun accounting for this eventuality. Stocks have corrected 20% and counting since the peak in December 2021. Real Estate Investment Trusts are down anywhere from 30-40% depending on the asset class and supposedly “safe” bonds got hit too. Long-term Treasuries were down 40% at one point.
The public markets are correcting towards a new reality. The story in private markets is different. Data are harder to come by by definition but it’s clear that values have not corrected a swiftly as in public markets. The reason for this is twofold in my opinion. First, by definition, there is no public market that is pricing your asset every day so it is up to private owners to value their own assets.
Many of us are home owners and I think you can sympathize with owners of private assets. You will find any way to be as generous as you can with your own house’s valuation. “That comparable that sold for less didn’t have a redone kitchen.” “The other had a no yard, etc.” Owners of private assets are usually required to mark their assets to “market” but what market is is open to significant interpretation. Some commentators call the process marking to “myth.”
The second reason values haven’t adjusted is that owners have simply stopped selling or have refused to lower prices. This is analogous to what has been happening in the housing market. As an owner, if you have a low rate 30 year mortgage, why would you sell at a reduced price and then buy something else with a much higher mortgage. You’d probably only do that if you were forced to and that is the state of many private markets today. Now let’s take a look at three of the largest private markets: commercial real estate, venture capital, and private equity/buyout firms.
Let’s Talk Commercial Real Estate
Real estate is probably the most talked about market. The biggest issue in commercial depends on which market you are in. For multi-family, the issue is really supply along with increased rates. More new multi-family housing will be coming on the market in 2023 than at any time since the early 1970s. The delays in construction during the pandemic and the attraction of increasing rents over many years conspired to stack up unfinished projects. This is already being reflected in sales. See below.
Of course, we all know office is taking a dirt nap but look at the data shared by StripMallGuy. Multifamily and industrial are worse than office. Yuck.
I do some private real estate investing as a limited partner/passive investor. The deals I see are almost identical to ones from a year ago. It’s quite flabbergasting to get a multi-family deal priced like it’s 2021 when public comparables are so far down. I’ve see deals promising a 4% return (or 4 cap) while Treasury rates are 5%. Why would I possibly do this deal?
Appreciation and ,“rate cuts are coming,” are usually the answer. This makes no sense. First, if risk-less returns are at 5%, there isn’t going to be any appreciation on a building paying 4%. Quite the opposite. With interest rates, I’m amazed that a 30 year old sponsor who has done two deals and lived through one economic cycle is suddenly speculating on interest rates like he’s George Soros. GTFOOH1.
Venture Capital
As bad as real estate is, I think values will come back to earth in the next 18 months and the sector will move on. The real bloodbath has been and will continue to be in the venture capital sector. The public companies in this sector have lost anywhere from 60-80% of their value. Most VCs are using some version of the following story to cope: it’s time to hunker down and wait for markets to reopen. We’ve been through this before in 2002. It’s during these challenging times that the real winners will emerge and at much more attractive valuations. There will the Googles and then the Facebooks and then the Ubers.
I’m suspicious of this narrative. While 2022 and 2002 have many similarities, I think the days of very low interest rates are over for a while. Cheap capital is the lifeblood of the VC business. When capital gets more expensive, this industry will struggle to produce good returns until it fundamentally changes how it operates. Those changes will reduce the ability of firms to scale quickly without profitability and reduce the number of outsized winners.
I would be very cautious investing here. Success will require flushing out huge portions of the current players and a complete readjustment in expectations and thinking amongst those who remain. This industry seems pretty dead to me for the next decade.
Private Equity
Private equity will have a harder time as well. This entire industry was built off of cheap debt and almost no one in it has ever seen persistently high inflation-as Bain points out below.
The market for companies in this sector is not quite as frozen as in VC or RE. While fundraising for new funds is down only 17%, the number of deals done last year (while off the peak) is still above 20192. The deal pace definitely slowed in the second half of the year but I think this sector suffers from misaligned incentives that keep it from freezing.
We have to remember how private equity managers get paid. It used to be that most of their compensation came from taking a 20% share of the gain they produced from selling the companies after buying and growing them. That's the “carry” portion.3
Increasingly, the managers have been making more of their money on the management fees they charge whether they successfully grow the companies they buy or not. Those fees are usually 2%. What that arrangement incentivizes managers to do is grow their funds rather than focus on finding companies where they can produce value.
This trend is particularly pronounced at large publically traded PE firms like KKR and Carlyle. Public investors know that it was more profitable to raise more money and charge 2% on it than to actually produce value and monetize it through carry. As a result, more and more of the profit PE firms produce comes from management fees.
That is a terrible trend for investors. PE will continue to buy companies for more than they are worth just to get the management fee. I see this sector as facing a large reckoning that will be hidden by mark to myth and ten-year fund lifetimes. Investors will get terrible returns but they won’t know about it until it is too late.
Conclusion
I’m pretty much staying away from private markets until they show signs of reckoning with reality. This sector lives off of OPM: Other People’s Money. Because of this, most of the players are incentivized to ignore reality and the lack of transparency enables them. Caveat Emptor!
As I said in Part 1, I think the largest opportunity will be in small domestic and foreign value stocks in public markets. I would take a bet that a value ETF like DFSV4 will outperform almost all PE, VC, and RE funds over the next decade and certainly the average one. However, remember that I think value stocks are going to lose more before they go up. So I’m currently concentrated in short-term Treasuries until I see that next leg down.
Finally remember, I am not an investment advisor. These are my opinions and do your own research! Also, remember that this is about trends and averages and my cautions are not absolute. There are always good deals. You shouldn’t avoid private markets altogether if you have specialized knowledge, connections, or an edge. Just be extremely skeptical and remember the incentives.
Look it up at your own risk on urban dictionary.
https://www.ey.com/en_us/private-equity/pulse
The term carry came from the portion of profits that the captain of a whaling ship received after the cargo was sold.
DFA Dimensional US Small Cap Value ETF