Weekly Edition #62
In this edition:
This is an old article but a good one. As we all know private equity’s main defining characteristic vs. public equity is that one is private and the other one is public. This means that private equity is more illiquid and harder to sell. The reason that it’s harder to sell is because there is no active market for these companies. You cannot buy and sell private companies in a public market since they have no publicly listed stock, obviously, otherwise they’d be public companies… This also means that there is no second-by-second record of what the price is. With a public company, say Apple, you can log in to Bloomberg or go on Google and look at the price second by second. You know exactly how much you would get if you were to sell your Apple stock. How much you could sell a private company for is much more complicated. Sure, you can have all sorts of sophisticated (read: with lots of variables to tweak to get the number you want) models for valuing a company, base it off expected cash flows or public company valuations, etc. But these are all just estimates. The true price you can get for a company is impossible to find out until you actually try to sell it. This means that public companies, by definition, will be more volatile. If you have a price that fluctuates constantly it will be more volatile than one which fluctuates only every 3 months, and the fluctuations are based on prices you estimate (read: make up).
Traditional finance literature says that investors should demand a premium for investing in illiquid assets, since they are taking on more risk. The risk with owning something illiquid is that you may need the money and won’t be able to sell the asset in time. However, it seems that investors much prefer owning illiquid, and non-volatile assets. The linked article has a comment from the ex-CIO of CalPers in which he calls private equity’s lag in reporting and model-based valuation as “time diversification”. Yes, you read that right, the person who used to manage $401 billion, said that private equity was good for a portfolio because it took a long time to report, and the valuation-based numbers were sort of made up. Under this framework we could open up a fund that invested in the S&P 500 (the most liquid security in existence), but only sent out reports every 3 months with a 3-month lag. According to Mr. Meng’s comment, this fund would provide “time diversification” since it would reduce the volatility of the portfolio. Except it’s completely made up and makes no sense!
We think the principal-agent problem is a big issue in asset management. For example, in a pension fund, the people making the investment decisions are not the owners of the assets being invested. Therefore, what is best for the manager may not be what’s best for the asset owner. In my toy example of the S&P 500, pension fund managers would love owning that fund because it would return exactly the same as the S&P 500 but with much less volatility. However, asset owners would be disadvantaged since they can get the exact same thing with more liquidity and more transparency in a publicly listed ETF.
Hedge funds generally charge management and performance fees. The management fee is charged as a % of assets under management. The performance fee is that the fund manager earns a % of the return of the fund. Usually, the performance fee is accompanied by a high-water mark. This means that the manager will only earn a return if the fund ends up above its previous highest value. So, for example if a manager’s fund has a net asset value of $100, and they lose money and end up at $90. They would need to recover those $10 before they start earning any performance fees. As you may have already seen, if a manager loses a lot of money, it is very hard (or at least will take a long time) before they start earning any performance fees. There’s an incentive for managers to close up the fund and start a new one.
Gabe Plotkin came into the spotlight a last year since he was short many of the meme stocks that went up by hundreds of percent and lost around 50% within a couple of months. He had a bad start to 2022 (unrelated to the meme stocks) and was down 21% in the 1st quarter. He is now asking his investors that if they want to stay, they were going to change the high-water mark to start earning performance fees again. I cannot say we agree that this is the right thing to do (he did lose around 50% of his investor’s capital), but we can see why he’s doing it. Shutting down his fund and opening up a new one is the same as doing this, but this is much simpler. Investors who don’t like it can leave. And the ones that stay would have probably also invested in his new fund if he were to launch a new one.
We think there’s a lot of value in sharing. Sharing ideas, deal flow, best practices, worries, opportunities, etc. For a while now we’ve been wanting to create a community of like minded individuals. If you think about it we all face very similar conditions. We have to invest facing the same conditions (low interest rates, high valuations, high inflation, etc.). We all want to diversify and grow our portfolios, some of us are at a stage in life where you’re thinking about leaving a legacy or transitioning your wealth to the next generation. We have the same fears, will inflation get out of control, will the war in Ukraine escalate to a war with NATO, will my kids know how to manage their wealth properly. Given these circumstances it makes a lot of sense to have a group where we can share and discuss these ideas, and share opportunities with each other. If you’d like to be included in this respond to this email and let us know!
And our minimum for entry won’t be $400m in assets. (Those of you who read the article will know what we mean).
Insider trading is a weird crime. Insider trading happens when someone trades using inside information, basically information that is private and is material to a stock. For example, if you work at a company and that company is going to buy another one; you cannot buy the merger target since you are using private information that is material to the stock you just bought. In a sense it is sort of a victimless crime. If you buy the stock and then your company announces the merger and the stock goes up, you made money, but who was the victim? Whoever sold you the stock was going to sell it anyways, even if it wasn’t to you. So, your actions didn’t directly hurt them. The victim here is the company you work for. In essence you stole the information from the company and used it illegally to profit.
In the linked article, a trader saw his firm’s clients’ trades and placed orders in his wife’s account moments before those trades were executed. Basically, he saw large trades coming and bought or sold stocks moments before. Therefore, he had a position when the large order came in and moved the price. He made roughly $8.5 million. Again, the victim here isn’t who sold him the stock he bought, but the clients who placed the orders he took advantage of. As Matt Levine says, insider trading isn’t about fairness it’s about theft.
We left this for last since it gets a bit in the weeds of market microstructure. When you send an order to a retail brokerage platform, that order does not go to an exchange to get executed (on most retail brokerage platforms at least). Rather it gets sent to what is called an internalizer. Internalizers are market makers who provide the service of executing orders. They claim to offer better prices than what you could get at an exchange, and they actually pay brokers to send them orders. The basic logic behind this is that they know who is sending the order, a retail investor; therefore, they know that it is an uninformed order, and they won’t lose money. When internalizers are executing orders at an exchange there is a risk that the orders come from a large institutional investor. Let’s say a large pension fund has to sell 1 million shares of stock. They don’t send the entire order all at once. They will break it up into smaller lots and work it throughout the day or throughout a couple of days. If you are a market maker and you see an order for 1,000 shares and you buy it, you have no idea that there are another 999,000 shares coming behind it. The risk you’re taking is that the 1 million share order will push the price down and you will take losses on every bit of stock you bought from them. Of course, there are people that say that they do this in order to profit from front-running the trades.
Thanks for reading!
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