Pengana Private Equity

Pengana Capital is launching a listed investment trust that will invest in global (but mostly North American) private equity funds. I am participating in the IPO.  I have been looking for an investment to replace IPE, which was taken over by Mercantile Capital. It's not an exact match as IPE invested in mostly Australian private equity. But now I am investing in Australian venture capital, so geographical diversification is good.

The fund will effectively be managed by Grosvenor Capital Management. I attended the "roadshow" where there were presentations from the CEO, Russel Pillemer and from a representative of Grosvenor, Aris Hatch. These were very helpful in understanding the potential value of this IPO. For U.S. regulatory reasons, the prospectus is missing any information on GCM's track record. However, there are two research reports on the IPO website, which are very informative, though technically they are only meant to be accessed by financial professionals.

The fund has really high fees. The base fees are about 2.4% p.a. If the investments exceed the 8% hurdle rate then three (!) levels of performance fees kick in. I estimate that the performance of the fund is related to that of the underlying investments as shown in this graph:

That's right, if the underlying performance reaches 25% the fees will be around 9%! Based on all the information I have, I still think the fund could return around 10% p.a. and so I think it is worth investing in.

An additional feature is that each $1.25 share will be stapled with $0.0625 worth of shares in Pengana Capital (PCG.AX). These shares will be distributed to investors after two years. Pengana will also absorb the costs of the float. Therefore, the initial NAV will be $1.3125 for a $1.25 investment. Pillemer justified PCG's 20% performance fee, for effectively doing nothing but choosing GCM as manager, on the basis of these giveaways. It seems that they won't get to keep much of the base management fee. Therefore, the fund will have to do well for Pengana to get paid.

The fund will take 4 years to get fully invested. In the short run they will invest in debt instead of equity. If there is a recession in the US in the near future, the fund can hopefully make some investments at good prices. So, the timing could be good.

Finally, it's interesting that the fund will not be a listed investment company but a trust. This means all earnings are passed on to investors in the form they are received rather than being converted to franked dividends. This is partly to make the investment more attractive to self managed super funds etc. if franking credit refunds are abolished.

Target Portfoilo Performance November 2018

The target portfolio gained 0.22% in AUD terms. Offsetting losses in Ausrtalian shares, gold, and unhedged foreign shares there were gains in particular in managed futures and buyout PE.

Private Equity and Venture Capital Indices

I commented that I didn't have a good proxy for private equity and venture capital. So, I went and found one and came up with these indices from DSC Quantitative Group. What they do is regress a quarterly indices of private equity buyout and venture capital funds from Thomson Reuters on various sector indices of listed stocks. They update these weights each time Thomson Reuters produce a new number. Because they are using listed stock indices as proxies they can then produce a daily index for private equity. The fit of the proxy to the underlying index is not too bad. This is for venture capital:

 The biggest deviation is during the financial crisis - unlisted private equity fell by more than the proxy index had predicted. When we compare the proxy to the NASDAQ total return index, it looks superficially like a leveraged version of the index:

When I regress it on monthly NASDAQ total return index data for 2008 to 2018, I get a beta of 1.15 and annual alpha of 6%. This suggests that venture capitalists add value by rotating the sectors that they invest in over time and it's not just about leverage:

Alpha is given by the intercept of 0.4% per month. I didn't do the proper CAPM regression where you are supposed to deduct risk free returns from the two returns series first. Given the volatility here and low risk free rates since 2008, I doubt it would make much difference.

Interestingly, the Cambridge VC index estimates much lower returns, close to the returns of the NASDAQ index itself.

You could do all this analysis for the buyout private equity index too. You'd want to regress that on the S&P 500 total return index instead.

Australian Corporation Tax

The Australian government has lowered the rate of corporation tax on small businesses and planned to lower the rate on larger businesses too. The latter was blocked by the Senate. The main reason put forward for reducing the tax seems to be increasing international competitiveness, though this is less important for small businesses that mainly don't have international investment in them. Today, the news is that the government wants to bring forward by several years the reduction to 25% for small businesses as a pre-election vote winner. Labor, by contrast, opposes this cut (they withdrew their policy to repeal the previous cut) and wants to raise all sorts of taxes on investment.

As an Australian investor in public companies I didn't used to care too much how high the corporation tax was. This is because when a company pays tax and then pays a dividend, Australian investors get a "franking" credit for the tax paid by the company, so there is no double taxation. Foreign investors usually can't use these credits, hence the argument to partly level the playing field  by bringing down the rate of the tax. If a company doesn't distribute profits and the share price increases and I sell my shares and pay capital gains tax, then there is double taxation. But the long-term capital gains tax is only half the normal income tax rate and so this isn't too bad (Labor want to reduce this discount too). Additionally, the price paid for listed shares takes into account that profits are taxed, which helps mitigate the impact of the tax on the rate of return that investors receive. Australian investors, though, are willing to pay more for Australian shares than international investors are, given their differential tax treatment.

Actually, I like getting franking credits, because after I deduct investment costs like margin interest they reduce the tax on my salary.

But as I think about setting up a private company, I increasingly like the idea of lowering the corporation tax. Profits that are re-invested in the business, rather than paid out as dividends, are greater if the tax rate is lower. Of course, this applies to listed companies too, and cutting the tax rate should raise the price of shares in a one time move. The more that we have existing investments rather than are buying new investments the more we should like increases in share prices... On the other hand, ot all the extra profits from lowering the tax rate will actually be realized. Market equilibrium should mean that after the rate of return increases, firms invest more, lowering the pre-tax rate of return. This mechanism is much like how stock market investors will buy shares raising the price and reducing the expected rate of return again. But lower taxes on investment are economically more efficient.

Internal Rate of Return and Private Equity

Private equity funds like to report the returns on their investment using the internal rate of return metric. The IRR is the discount rate which results in the net present value of the stream of cashflows from the investment being zero. This article points out that it is only the true compound rate of return if you can reinvest the payouts that you receive over time at the same rate of return (r.o.r.). This is correct. But it then goes on to say that IRR is meaningless if you can't reinvest the distributions at the same r.o.r. I don't think that is right. If the IRR is higher than the r.o.r. that you can invest the distributions at, then your r.o.r. from investing in the private equity investment and reinvesting your distributions is greater than the r.o.r. you'll receive by just investing in your alternative investment (and vice versa). Your actual r.o.r. won't be as high as the IRR but the IRR is still useful for making decisions. The main issue is that you need to deduct the funds fees to get the true IRR. Often they will report that they made a $1 million investment and sold for $2 million and give the IRR without deducting fees. Probably as a back of the envelope calculation you could deduct 1/4 of the stated IRR in these cases and then compare to your alternative r.o.r.

So, for example, in Aura's latest report to investors they reported IRR's to date on two investments of 59.5% and 29.2%. So, yes, these are very good. Of course, those are the investments whose carrying values they are marking up. They report a 21.3% IRR on an investment they are exiting. But then there are others that are just breaking even.

New Investment: BlueSky Alternatives Fund

I had read back in April about BlueSky's battle with activist hedge fund Glaucus. As a result, the share price of the management company (BLA.AX) collapsed and they undertook a thorough review and independent valuation of all their investments. Listed investment company (closed-end fund) BAF.AX, is a fund of funds, investing in BLA managed investments in real estate, private equity, agriculture, and water rights. The price of this fund also fell, though not as dramatically. The valuation of all but one of its investments is now complete and the net asset value is AUD 1.13 per share. On Friday the stock was trading around AUD 0.80. The company is buying back a lot of stock which is supporting the price. I made an initial investment today and could add more if my thesis that it should rise, plays out.

Sophisticated Investor

I got an e-mail about an Australian venture capital fund and decided to follow it up. The information the fund sent me looked very interesting, but it is limited to wholesale and sophisticated investors. In order to be classified as a wholesale investor you must have individually (not with your spouse) AUD 2.5 million in net assets or AUD 250k in gross income. I don't qualify individually on this basis, though we jointly would qualify on the second criterion and in the near future I will qualify on the first criterion. So, I told the fund salesperson that and they sent me a questionaire to see if I qualify as a sophisticated investor who understands the risks involved. I just sent the form back. If they qualify me I will invest in the fund and disclose more information here. Overall, I plan to invest 5% in private equity and it makes sense to allocate half of that to venture capital and half to buyout etc. IPE and OCP cover the later stage private equity in the portfolio 2.5% roughly equals the fund's minimum investment requirement, so that is what I will invest, if approved. Interestingly, early stage venture capital investments are tax free in Australia. That also means, of course, that you can't claim losses against your income tax.

In other news, I redesigned a trading algorithm from the bottom up on 2018 data, using the same forecasting model. It has a bit lower return and larger drawdowns, but all the rules make theoretical sense and it sticks to the model predictions rather than reversing direction if stopped out. In fact, it only uses a stop when initiating a new direction - this is to guard against the new signal being noise - the stop is removed after the direction is confirmed. After that I would just use hedges. Next, I need to backtest it for 2017 and 2007. I think 2007 is analogous to 2018, while 2017 is very different - a constantly uptrending market.

The model is currently short, but I am not trading it without backtesting and also there is higher risk entering a move already underway, as the model is unlikely to time the exact optimal turning point to reverse direction.

P.S. 25 April
I backtested the model for the second half of 2017. Results are not as good as year to date in 2018 but they are much better than the model I was using at that time when the fake stops are removed from the model. The main issue is that my model tends to underperform the market in strongly trending markets as it keeps looking for opportunities to go short. We can compensate for this by trading 2/3 the model and 1/3 just long the index. This means that when we go long we use 3 times the position we use when we go shorter. This results in a more consistently rising equity curve. Increasing position size when going in the direction of the established trend definitely makes sense.

P.S. 27 April
They accepted me as a sophisticated investor.

Facebook Investor Peter Thiel Makes Thousand-fold Return

The fall in Facebook shares since the IPO isn't much of a worry for the earlier investors. Peter Thiel sells 80% of his Facebook shares for $400 million. He bought his stake in the company for $1/2 million. Another way to look at it is that he made a 137% p.a. return in the eight years since investing.

P.S. 22 August

Actually, he made more than a 2000-fold gain.

More Adjustment to my Mom's Portfolio

We have now made a bunch of moves in my Mom-s portfolio. First we sold down two bond funds and increased our investment in the Man-AHL diversified futures fund. And we moved £100k to her home country and invested in a bunch of stuff there. That reduced the allocation to Sterling investments. But we still have a lot of money left over from the bond sales.

The bank suggested various funds including some Swiss real estate funds (including this one), the Jefferies Global Convertible Bond Fund, a UK stock fund, and a fund invested in the Rogers Commodity Index. I don't feel like taking a long only bet on oil and other commodities (Rogers is 40% petroleum) and the problem with the Swiss real estate funds was that they are very concentrated on residential property in Zurich and are trading at around a 25% premium to NAV. So I ruled all of these out. But I think we will invest some money in the other two funds. Convertible bonds are interesting because they provide some potential inflation protection compared to a regular bond by being potentially convertible to equity.

I have now suggested to invest the rest in ETFs and closed end exchange traded funds. As an investment in real estate I propose VNQ and DRW. VNQ is a US REIT ETF managed by Vanguard, which means it has a lower management expense ratio than other funds. DRW is a non-US fund from Wisdom Tree which is based on a dividend weighted index. It seems to be the best performer of various international REIT ETFs I checked out. I think we should increase our overall exposure to stocks and particularly to Asian and emerging market stocks, where we are probably underweight. So I'm recommending VWO and DGS- again one Vanguard and one Wisdom Tree fund. Finally, two stocks that I own personally - GTAA and CHN (The China Fund). I think these are two well-managed actively managed funds.

Another asset class that isn't in the portfolio is private equity, but it is a challenging asset class to invest in as a small investor in an effective way. I personally own shares in Leucadia National (LUK) and 3i (III.L), which I think are somewhat better than average exchange traded approximations to this asset class. I'm not impressed by the available ETFs, which I did just check out. So, I think we'll pass on this for now.

When we have all these changes in place I plan to report back on how we have transformed the portfolio. One result is that it is more similar to typical endowment and pension fund portfolios, which has been my long-term goal here.

iSoft

iSoft (ISF.AX) suspended its shares pending an "announcement". I just wish companies would explain something about why they are halting trading. The Guardian has the story. Apparently a partner firm looks ready to buy them out. My interest is due to our holding of Oceania Capital Partners (OCP.AX) who made a disastrous large investment in iSoft. Most of the loss of value happened very quickly last June and as OCP is trading way below NAV I didn't sell. OCP is also in a trading halt. At the current share price we are making a small profit of a few hundred dollars on our investment in OCP. At the NAV we would be making a profit of several thousand dollars. And the company is in the mode of winding up and returning capital to shareholders. With all these companies returning capital we need at some point in theory to make new investments in the private equity and hedge fund asset classes. The question is whether we can find good investments of that sort.

Inefficient Markets

With all the talk about the supposed negative effects of the "efficient market hypothesis" that supposedly caused the GFC it's worth pointing out how the markets are often blatantly inefficient. Oceania Capital Partners (previously Allco Equity Partners) has a big stake in iSOFT (ISF.AX). Based on my calculations it is currently worth $A3.10 per share. The company also had 43 cents per share of cash as at 30th June and 24 cents of "realisable securities". Liabilities were 7 cents per share. That totals $A3.70 per share. Yet the stock trades for $A2.77. We'd have to believe that their two private equity holdings have a negative value of almost a dollar a share instead of the $A1.25 per share that they claim for that to be a rational price. Yeah, we should probably take something out for the cost of future management fees but still the stock trades at a ridiculous discount.

I've persuaded myself not to sell any yet :)

EDIF

In the ongoing Everest Financial saga, the "direct investments" in the EAIT fund of hedge funds is being separated out into a standalone fund as of 31 July. 62% of this new fund is invested in Babcock and Brown European Ports Investments and the other investments are also in infrastructure or real estate. Therefore, I'm classifying this as a real estate investment as well as a "passive alpha investment" and as the investment is in my understanding hedged I'm going to continue to count it as an Australian Dollar investment.

IPE Placement and Rights Issue

IPE, a private equity fund of funds listed on the Australian Stock Exchange placed around 6 million new shares with a fund manager for 19 cents each and announced a 1:1 rights issue at 17 cents. The current share price is around 30 cents while net tangible assets are supposedly 84 cents per share. I had been looking to double my position anyway in order to recycle the capital return that Allco Equity Partners will be paying out and rebalance my private equity portfolio. It's good I didn't buy more shares at a higher price... on the other hand this announcement seems to have pushed up the share price, so maybe I should have... I will participate in the rights issue.

The equity raising will be used to pay down existing debt. The fund has negotiated a new $20 million line of credit with National Australia Bank contingent on the equity raising (which is underwritten). The new loan will be used to meet future expected cash calls from the private equity funds that have already been invested in. I suppose, originally they expected to meet these using distributions from other funds, which in the current environment have dried up.

Hidden in the announcement though is a plan to eventually liquidate the portfolio. Of course this is subject to shareholder approval. This would be a pity. I'd prefer them to delist as EAIT has.

P.S. 10:52am
IPE's price is now down on the announcement.

AEP Announces Program To Maximise Shareholder Value

From the press release:

AEP ANNOUNCES PROGRAM TO MAXIMISE SHAREHOLDER VALUE:

• $60 million pro-rata return of capital proposed
• Continuation of business model for existing investments
• Suspension of new investment activity for the time being
• Shareholder vote in two years to determine future direction of the Company depending on
share price performance

AEP is a private equity company listed on the Australian Stock Exchange. The stock has been trading at less than 50% of net asset value for a while now. So it is good that they are looking to try to boost the share price, which indeed did rise on Friday following the announcement. It would be a shame though if this opportunity for retail investors to participate in private equity was wound up in the end.

Venture Capital: 1992 vs 2000

Interesting comparison of the outcomes for venture capital invested in 1992 vs. in 2000. The 2000 vintage is only now beginning to pay off in terms of distributions, but still has lost money overall. As in 2007 venture capitalists invested heavily at the top of the market. On average they don't seem a lot smarter than anyone else. Though there is some evidence that the best are good.

Carbon Planet

Carbon Planet is a privately held Australian company "whose mission is to enable every individual and business on the planet to manage their contribution to the defining issue of our age, global warming. Established in 2000, Carbon Planet has been working with businesses around the world, helping them quantify the risks and explore the opportunities emerging in the carbon constrained economy." They are raising money through both a retail and institutional fundraising round to help in their expansion. This kind of venture fundraising from retail investors is legal in Australia if sufficient disclosures are made in the offer document. But it's rare. Which makes me wonder why they are prepared to go through the hassle of raising money from the public. They plan on listing on the ASX by the end of 2010.

The plan is to raise $(A)4 million from retail investors in amounts as small as $2,000 and $10 million from institutional investors. The shareholders equity of the company was -$2.7 million at the end of 2007 and they lost $2.3 million in 2007. The main liabilities are loans from directors. Since the end of 2007 the firm has already raised $6.3 million from private equity placements for it seems 151 million shares for an average of 4.2 cents a share. But 82% of issued shares to date are held by the directors. The retail placement share price is 50 cents. A massive paper windfall for the the investors (mainly the directors) so far this year. The company states it has $2 million in the bank at the moment and has not repaid the director loans. So did it burn $4 million so far this year? It would be really nice to have accounts for more recent months, but none are provided. The expansion plans are ambitious but vague beyond the very near future and they admit to a very large number of competitors in Australia and doubtless plenty more elsewhere. On the plus side, the directors and key employees have a strong entrepreneurial track record including founding and profitably selling a technology company.

Given the short track record, ambitious but vague plans, lack of up to date financial information, and seemingly exorbitant valuation placed on already issued shares (the company is valued at $85 million based on this placement or about 100 times 2007 sales) I'm not planning on participating in this investment. Maybe I'm missing out on the next Google, but I don't think so.

Glaring Market Inefficiency

Allco Equity Group continues to trade at a ridiculous valuation of $(A)1.75 per share while having net assets of $4.76 per share. The value of shares and convertibles it holds in IBA Health based on their current ASX listed price is worth $1.81 per share of AEP according to today's earnings release. The firm has $1.28 in cash and other marketable securities per share and its outstanding loan to IBA is worth $0.60 per share. The loan is due to be repaid in October. Its unlisted investments are worth $1.01 per share according to the company. Assuming these are worthless (which they're not - they earned $3.5 million in after tax profits for AEP this financial year while AEP's share of IBA's earnings was $4.4 million) AEP is still worth $3.75 per share. Obviously, we know that closed end funds can trade at a discount, but this is nuts.

The company is issuing a franked dividend of 6 cents per share in October (record date in early September) and will buy back 5% of its stock starting in mid-September.

BTW, I just created a new label category: "Private Equity".

Large European Listed Private Equity Firms

The firms discussed in this post are the European firms among the top 10 in the LPX index. I've already covered (and invested in) 3i - the firm with the largest weight in the index.

Wendel: This French firm seems to be more of a buy and hold investor in the mode of Berkshire Hathaway or Loews than a private equity firm. RoE is less than 10%. So this doesn't look attractive as a LPE investment.

Partners Group: "Is a global alternative asset management firm with over CHF 25 billion in investment programs under management in private equity, private debt, private real estate, listed alternative investments, hedge funds and alternative beta strategies. Partners Group is headquartered in Zug, Switzerland." In other words, investing in this is like investing in BX. You are investing in the management company, not the fund.

Ratos: Is a pure listed private equity firm investing in Scandinavian firms. But its share price is way above book value and its RoE is not very impressive. Analysts are not positive on it.


Eurazeo: Private equity investor that also has significant stakes in listed companies and real estate. Almost all its investments are in France but many of those companies are multinationals. Analysts like it and the financial data I've examined looks pretty positive but erratic over time. It's worth considering.

3i vs SVG

After finding that I couldn't invest in the Bear Stearns and Lehman Brothers funds I considered investing in two large UK listed private equity funds - 3i (III.L) and SVG (SVI.L). 3i is a private equity firm that invests on its own account and also manages funds for investors. SVG has the same combination of businesses but does not originate its own private equity investors, investing instead in Permira's funds. SVG was created in the reorganization of Schroder funds which also resulted in the creation of Permira. This adds an extra layer of costs, which is one reason that I think SVG appears to be underperforming 3i.

3i mainly splits its investments between buyout and late stage venture or growth investments, while Permira is primarily a buyout outfit. Both SVG and 3i have some infrastructure investments as well. 3i is mostly invested in Britain and continental Europe with smaller amounts elsewhere. SVG has a large part of its investments in North America. 3i invests in smaller companies than Permira typically does. This is reflected in the commentary from the chairman and CEOs of the two firms in their most recent annual reports. 3i's management dismiss the credit crunch as mainly affecting deals larger than those in their portfolio, while SVG's management are gloomy about prospects.

Compared to conventional stock or fund investments 3i looks very cheap:

• It trades at a discount to book value. And it is well known that private equity book value is usually conservative. Most realisations of investments yield higher prices than the carrying value - so-called "uplift". Recent book value is £10.60 while the share price is £9.09. A 14% discount. It has traded at a premium in the past.
  
  
• The trailing P/E is only 5.
  
  
• Total investment return after expenses for the 2008 financial year that ended at the end of March was 18.6% on initial shareholders funds. In 2007 3i earned 26.8%. The underlying gross portfolio returns were 23.9% and 34%. From 2004-6 the gross returns were 19.4%, 16.7%, and 24.4%.
  

The buyout line of business has done even better with a 54% gross rate of return in 2008. The IRR of the different buyout funds has ranged from 35-62%. SVG reports that Permira's underlying buyout funds averaged a 20% IRR while SVG's NAV has grown at an average 14% p.a. since listing. It's not surprising that most analysts that track 3i rate it an buy or outperform. The modal recommendation on SVG is "hold".

I bought 200 shares of 3i for £9.06 each. Commission was £6 plus a 0.5% stamp tax which is a transaction tax on share trades in the UK. No wonder CFDs are so popular in Britain. The stamp tax doesn't apply to them. It'd be hard to day trade with a 0.5% tax on top of commissions.

Next I'll look for a second European private equity investment.

The Best Private Equity Funds Show Persistence

There has been endless debate about whether the best mutual and hedge fund managers show real skill in terms of being able to achieve persistent outperformance. A recent paper by the Boston Consulting Group presents evidence that the best private equity funds do show persistent outperformance as shown in the key figure below:



As I argued in yesterday's post it is important to pick good private equity funds as the average fund globally shows high risk but not neccessarily risk-adjusted outperformance compared to public equities. There is plenty more interesting stuff in the paper.