The Private Eye

9 June 2022

Pascal Blackburne

Little has unfortunately changed over the last month, with the only positive news stemming from China where lockdowns are being lifted and economic stimulus measures now likely – if the government’s 5% full year growth target is to be attained. An acceleration of the Chinese engine will, however, only add to upward pressures on oil prices, OPEC’s margin for production increases being limited. Which means further rate hikes, continued pressure on richly valued, unprofitable companies… and a broadening divergence between the public and private equity markets.

“The invasion Vladimir Putin thought would last days is now in its fourth month”. These are President Biden’s opening words in a recent New York Times Guest Essay. He then goes on to explain that the US will be providing the Ukrainian army with more sophisticated weaponry. Whether this will suffice to eventually see Russia admit that victory is not possible and opt to pull out of Ukraine remains an open question. For now, the world must contend with an ongoing war, lower (or re-routed to India/China) Russian oil shipments and, possibly most worryingly, food shortages. As a result, the Eurozone headline consumer price index (CPI) hit 8.1% in May – a level unseen in decades. Excluding energy, the figure was 4.6% while the core index (which also excludes food) stood at 3.8%. This being well above its target, the European Central Bank (ECB) will soon be forced to follow the Federal Reserve’s footsteps in hiking interest rates.

The past weeks have shown that even a moderate (to date) upmove in rates can inflict substantial damage on stock markets, the loss-making technology “darlings” being particularly impacted. Excluding the largest (profitable) companies, the IT sector has lost half its value and some names even more. The generally stated explanation is mathematical: higher rates mean that the present value of future estimated earnings is lower, and in publicly traded markets the price adjustment is immediate.

In the private equity market, however, it is not only prices that are adjusting but rather the ease of access to capital, as well as business timeline requirements. Entrepreneurs whose company prospects are, on the surface, no different than yesterday are having some trouble understanding this change in conditions. Or perhaps not wanting to understand.

Indeed, over the past couple of years, they had become used to money flowing freely, with private equity fund managers often literally fighting over potential ventures. As the public/private valuation gap swells, this eagerness to make deals is fast subsiding. Worse, private equity investors are now also pushing the companies held in their portfolio to “extend their runway” – that is to reduce the pace at which they are burning cash, so as to be able to survive longer without additional capital injections.

One might object that private equity funds are sitting on huge cash piles, so need not react so drastically. The big misunderstanding here, though, is that while massive amounts of capital have indeed been committed to the private equity space, fund managers only deploy it when they see investment opportunities. And right now, they are preferring to hoard cash.

In essence, anxiety has made a comeback into financial markets. Whether it turns into full-fledged fear will depend on how the situation evolves, from both a geopolitical and macroeconomic perspective. Assuming a solution to the Ukrainian conflict is found, China delivers a positive surprise, US growth holds up as it generally does ahead of mid-term elections and the interest rate trajectory does not prove too steep, then investor sentiment will stabilize and the party can go on. But if, on the other hand, the war keeps raging, inflationary pressures intensify, central banks become very aggressive and private investor pockets stay closed, then an economic recession will be inevitable and financial markets will undergo a severe correction.

Positioning portfolios in such a binary world is challenging. For now, we are sticking with the more optimistic view, albeit focusing on reasonably valued cash-generating companies and looking to add more option protections on a volatility pullback. But we will certainly be keeping a close watch for the “canary in the coal mine” – such as the default of a mid-sized technology darling. To risk an analogy: back in 2007-2008, Bear Stearns’ default was the canary… warning the world of the pending Lehman explosion.

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