Third Quarter Letter

October 20, 2014

Dear Friends of PPE,

Over the last six months we have had solid deal flow and have seen a number of good opportunities.  However, the market continues to be challenging for us as valuations remain high and competition fierce.  We are currently finalists in three deal processes and remain optimistic that we can put some points on the board this year.  Without a lot to talk about that we can discuss publicly, for your entertainment I’ve decided to play amateur economist.

All value investors are by nature contrarians, so we look for patterns (in companies, industries and the broader economy) that may cut against the common wisdom. If we can achieve insights that are not widely understood, we can make better investment decisions.  In thinking about the US economy recently, I asked myself: “What if the common wisdom is wrong?”

What if?

The Federal Reserve has nursed the US economy back from the brink of disaster. The stock market has been on a tear and the economy is returning to normal. Economists are confident that over time economic growth will bring our fiscal situation into better balance. Of course, there are still some free market fundamentalists and other kooks wringing their hands about the Fed overreaching and manipulating the financial markets but on the whole they have been proven wrong—our economy is back on track.

Or is it? What if the kooks are actually onto something? What if monetary stimulus is not enough to fix our economic problems long term? What if the Fed’s stimulus programs have actually increased the risk of another, possibly larger, financial crisis in the future? What if, far from shoring up our economic foundations, the Fed has undermined the very mechanisms that would have allowed our economy to return to long term equilibrium?  Unpleasant questions, but worth considering.

In pondering these questions, it is worth recalling that (a) the Fed’s monetary stimulus program is an economic experiment whose ultimate results remain unknown, (b) we’re probably only in the third inning (at best) of watching this play out, and (c) the only other country to have tried anything like this without accompanying structural reform (Japan) has experienced 25 years of economic stagnation and has a current debt-to-GDP ratio of 240%.

Is Stimulus Enough?

The common economic wisdom seems to be that stimulus alone is sufficient to return the economy to long term health. The theory is that the massive boost to liquidity provided by the Fed has increased asset values, stimulated demand and that these will create a virtuous cycle of growth that will ultimately return everything to “normal”. This is possible but it is far from certain. I doubt that even the Fed has a high level of confidence in this scenario. The problem is that underlying conditions in the economy are anything but normal and the recent benign conditions engineered by the Fed are likely unsustainable.

A significant but sometimes overlooked issue related to the Fed’s stimulus program is the strong probability that the program has widespread unintended—and potentially negative—consequences. Like the Heisenberg principle in quantum physics, the Fed’s stimulus program is almost certainly changing the behavior and motivations of the economic actors it is seeking to influence. We can see this in Wall Street’s exuberance and appetite for risk over the last few years. We may also see this in Main Street’s reluctance to hire workers and invest in the real economy.

From a businessperson’s perspective, consistent economic rules and a market mechanism for achieving long term economic equilibrium are essential preconditions to planning for the future. They allow a business to rationally weigh probabilities and ultimately make long term investments in people and productive assets. By contrast, recent US economic policy (including that of the Fed) has been characterized by shifting economic rules, financial market manipulation and, in some cases, picking winners and losers. A consequence of these policies is uncertainty. Given this, perhaps we should not be surprised that businesses have seemed reluctant to invest and hire for the long term, notwithstanding superficial improvements in the economy.

Finding Equilibrium

Market forces cannot work properly in an environment of massive, sustained monetary stimulus. The Fed knows this and in fact a prime objective of the Fed’s monetary stimulus was precisely to stop market forces from working. If we rewind to mid-2008, the proximate cause of the Great Recession was the bursting of the real estate bubble. The bursting of the bubble was the market at work, seeking to find a new equilibrium after a period of excess. Since then the Fed has worked to reverse the judgment of the market.  It’s easy to see why they wanted to do this but it is reasonable to ask whether there might be an element of hubris here.

Fed policymakers have acted as though the market crash was the problem. As a result, the policy response of re-inflating the bubble has been, in some ways, like shooting the messenger. In fact, the market crash wasn’t the problem, the real estate bubble was the problem. In a sense, the crash was the solution—admittedly a violent and ugly solution—but fundamentally an instance of the market seeking a new, more sustainable equilibrium following a period of speculative excess.

If you believed, as the Fed apparently did, that the market crash was the problem, you would do the logical thing—you’d try to re-inflate the bubble to go back to the way things were before the crash. This is precisely what they’ve done—asset values have been re-inflated to pre-crash levels, creating an illusion of wealth that, in the absence of other fundamental policy changes, is sustainable only with a continuation of an aggressive easy money policy.

What if re-inflating the bubble was not the answer—what if asset values should be lower? What if there is insufficient organic demand in the market to justify today’s inflated asset values over the long term? That would suggest that the real problem is not that asset values fell too low in the crash, but that debt levels—driven by pre-crash bubble economics—were too high in light of the true fundamental value of the corresponding assets. If so, reducing leverage would be the key to establishing a new foundation for growth.  Surely, you think, leverage is no longer a problem—debt levels must have declined as borrowers and governments deleveraged following the recession. Shockingly, the opposite has happened—global debt to GDP has not declined post-recession—it has continued to rise at an increasing pace, driven in part by the Fed’s focus on easy money and credit.

By keeping asset values high and credit freely available, the Fed has arguably hindered the healthy process of debt restructuring that might otherwise have allowed the economy to find a new, sustainable equilibrium and foundation for sustained growth. Instead of de-leveraging, leverage and overall financial risk in the global economy have increased. Looked at from this perspective, we have a disturbing situation—a global bubble that is bigger than that of 2008, a monetary policy that has used most of its bullets, and a Federal Reserve that is risking its own credibility (and that of the currency it oversees) by overtly acting as the ultimate guarantor of global risk.

Like Scotty’s warning on the Starship Enterprise, “Cap’n she’s gonna blow!” we must recognize that the pressures building for another financial crisis are substantial. The break point is probably far from imminent, but we already have some warning signs. Asset values are in many cases re-entering bubble territory, demand is still weak and the Fed has used a lot of its ammo. Allowing the economy to restructure organically through debt restructuring is now politically unfeasible. The Fed may have to double down on its stimulus bet, shouldering even more of the economic risk that is, in a healthy economy, naturally borne by the private sector. It is unclear whether there is a viable exit strategy for the Fed in this scenario.

Structural Reform

Of course the conventional wisdom may be right—we may dodge the bullet and the economy may heal itself over time, giving the Fed the ability to make a graceful exit. However, if this does not happen the results could be fairly catastrophic—either in the form of a sudden crisis or in a long inexorable economic malaise.

We have the ability now to significantly reduce the odds of a worst case scenario.   The window for action is narrowing over time, however. Dodging the bullet will require strong political leadership and a bipartisan approach, two things that have sadly been in short supply in Washington. However, miracles do happen on occasion (witness the fact that LeBron James returned to the Cavaliers!).  With the right policies it is possible to lay the foundation for a growth economy that can support today’s (otherwise unsustainable) asset values and point the way for continued growth in the future.

Everybody knows what needs to be done—tax reform, entitlement reform and structural reform. A good, bipartisan roadmap for reform already exists in the Simpson-Bowles Plan. These reforms, even if imperfect, would create room for the Fed to retreat, shrink its balance sheet, and assume a more appropriate role in the economy. Tax reform would make us more competitive and address some of the gross injustices in the tax code. Long term fiscal balance would significantly reduce the overall risks to the economy from excessive debt. Structural reform would make government more efficient and responsive. Real businesses on Main Street would be able to plan for the future with confidence, leading to job growth and investment.

Is such reform possible? Oddly, the Fed’s success to date has, in a perverse way, been an enabler of the partisan gridlock that has put our long term economic future at such risk. With the illusion of prosperity, there has been no urgency in Washington to stop the partisan food fight and get down to business. Will it take another financial crisis to spur short-sighted politicians to action? That would be unfortunate, especially since there is such a significant potential for the next crisis to spiral out of control—possibly out of the control of even the wizards at the Federal Reserve.

Calling all Adults

I am not a Fed basher. I acknowledge that they had little choice but to pursue an aggressive monetary stimulus program in the wake of the 2008 financial crisis. Did the Fed’s stimulus program increase the level of moral hazard in the financial markets? Sure. Did it shift risk from financial speculators to taxpayers? Of course. Did it interfere with the healthy process of debt restructuring? Probably. Did they go too far?  Time will tell.  Did they have any choice? No.

Now, however, the Fed’s job should be over. It is now time for the President and Congress to fix our economy with real, long term structural reforms that give us a foundation for future prosperity.

It is important that the adults in Washington (if there are any) understand the urgency of fixing this problem while they can. Fun as it has been for the last six years to fight over gay marriage, immigration, the President’s golf schedule and other thorny issues, we actually have a far bigger problem to solve—shoring up the foundations of our economy so that we can continue to have the freedom to fight about the little things that bother us.

John Mueller

Partners Private Equity LLC

P.S: You might ask, “What does all this baloney have to do with your approach to private equity investing?”  I suppose the answer is that it gives us humility regarding the many things we don’t know.  It reminds us to avoid the madness of crowds.  And it cautions us to resist the siren songs of frothy valuations and excessive leverage.

First Quarter Letter 2014

 

April 20, 2014

Dear Friends of PPE:

Just our luck. We decided to start a value-oriented private equity firm just when the Fed began pumping a massive amount of liquidity into the economy, inflating asset values to record levels. We had bragged to our investors about our sober and disciplined investment style. We assured them that we have an investment approach for all seasons—that even in periods of excess we can find diamonds in the rough and deliver solid returns. As it turns out…not so much.

We are simple people—we want to buy decent businesses at fair valuations without using excessive leverage. We want to be good corporate stewards, help our businesses grow, and ultimately sell them at a profit so that we can deliver promised returns to our investors. If we do this properly everyone benefits—the seller, company management, employees, our investors and us. Very old school.

However, as we were moving into our new offices, unpacking boxes and booting up our computers in early 2013, some early warning signs started to emerge. Private equity valuation multiples were approaching all-time highs, and ultimately would eclipse even the outlandish multiples of 2007 and early 2008 (just before the last bubble burst). Lenders, awash in liquidity and desperate to put money to work, were lending at record multiples of record earnings. We started to bid on companies that met our investment criteria and were surprised to find that we were consistently getting outbid by wide margins. And the margins by which we were losing seemed to increase over time.

Long portage through a frothy market

 

Then and Now

I am a bit of a dinosaur. I was trained by a prominent value investor, Martin Whitman of Third Avenue Funds, who is a consummate contrarian. Marty has always had the insight and level-headedness to take advantage of irrational market fear and invest at compelling valuations when others are losing their heads. He trained me to use sound investment judgment, avoid the madness of crowds, and to be a good corporate steward when we acquired a business. With this simple approach we achieved outstanding investment results. Today, it seems, the world is not so simple.

I may be a dinosaur but I’m not dead yet!

 

What has changed since then?

First, the capital markets have matured. The fear that used to infect investors when a business fell out of favor has been mitigated by a much better understanding of value in all corners of the capital markets. As the saying goes, nature abhors a vacuum, and Wall Street abhors an unexploited arbitrage. Over time, there has been a proliferation of opportunistic investors focused on taking advantage of systemic imperfections in the capital markets generally and in the private equity market specifically. Buying a business with a “margin of safety” has become significantly more difficult.

Second, M&A investment bankers have perfected the art of the auction. Sale processes, even for small companies with as little as $3 million in EBITDA, are run professionally. Offering materials are distributed to a broad universe of acquirors, often numbering 50 or more (including both strategic and financial buyers) and successive bidding rounds tease out the highest possible valuations. Indeed, with a large, statistically valid pool of bidders in most sale processes, the market has become extremely efficient. Deals are priced to perfection.

Third, the good long term performance of private equity as an asset class has attracted a flood of capital. According to the Private Equity Growth Capital Council, there is currently over $1 trillion of private equity “dry powder” looking for a home, about half of which is focused on leveraged buyout transactions. Regardless of market conditions, this capital will be put to work. Institutional investors’ asset allocation strategies require that the private equity slice of their pie chart be filled and private equity sponsors know it is their job to meet this objective.

Beyond these fundamental changes in the structure of the market, there are some recent economic anomalies that have further influenced the inflation of private equity valuations. A prime mover of these anomalies has been the Federal Reserve, whose policy of quantitative easing and low interest rates has created distortions in the economy that have forced up asset values generally, including those in private equity.

Moral hazard? What moral hazard?

Overall, the Fed’s policies have had the unintended consequence of creating a high level of moral hazard throughout the capital markets. Professional investors are seemingly more focused on the Fed’s quarterly meetings than on efficiently allocating capital in a real market economy. The “creative destruction” that is central to a free economy seems to be a thing of the past. The real estate bubble has been reinflated, banks with troubled loans are permitted to “extend and pretend”, and every stock market hiccup brings another round of quantitative easing. Investors are conditioned to believe that risky, speculative behavior will always be insured against loss by a “Fed put”. This is almost certainly influencing investment decisions in private equity.

A Bubble?

Asset managers allocate capital in large part based on a rear view mirror look at performance. Asset allocators use Monte Carlo simulation models to extrapolate historical returns and correlations into the future as an aid to decision making. However, these models are inherently based on the principal of “all else being equal” and do not have the sophistication to incorporate changes in the market itself or the future impact on the market of the decisions based on this very modeling. This can create perverse results at times, including asset “bubbles”. The internet and real estate bubbles are recent examples in which expectations based on historical data (yet arguably devoid of common sense) drove behavior that in retrospect seems irrational. Indeed, exuberantly irrational.

Is there a risk that the private equity market is entering a bubble phase? On the surface it seems improbable—private equity sponsors are investment professionals that have long term investment horizons and who perform extensive due diligence on their investments. However, even private equity firms are captive to assumptions based on the prevailing status quo. Today, the prevailing EBITDA multiple for all buyout transactions is a breathtaking 11.6x (Q1 2014) according to Pitchbook. Compare this to average EBITDA multiples of 5.9x in 2002 (according to Standard & Poors)—roughly half the current level. In the intervening period, multiples have risen inexorably (but for the sharp temporary decline in the wake of the 2009 recession).  (Multiples at the smaller end of the market where we play are lower, but the trend is identical.)

---

 

Oops!

How do private equity investors justify paying these nosebleed prices?  There may be an element of hubris here—investors that have done well in the past based on a rising tide of asset values may be inclined to attribute success to their own brilliance rather than dumb luck. They have been trained to ignore the risks that come with excessive valuations, having been repeatedly rewarded for doing so.

However, consider the facts. At current multiples, if a sponsor funds a deal with 50% equity (compared to a historical norm of perhaps 33%) the acquired company will still be burdened with debt equal to almost 6x EBITDA. For most companies, it is a mathematical impossibility to service this level of debt, pay taxes, make necessary capital expenditures and still grow the business. It is only possible with continued access to cheap, patient capital such that the debt never actually gets repaid until the company is sold (securities with these characteristics were previously known as equity). At the time of the sale, the sponsor is counting on selling the company at the same or a higher EBITDA multiple to another buyer with access to the same cheap, patient capital. Optimistic assumptions layered upon optimistic assumptions.

So if we are worried about a bubble it is logical to ask the key question of whether it is likely that EBITDA valuation multiples are likely to stay the same or increase. Well, let’s see… Private equity EBITDA multiples are at historic highs. Since high private equity EBITDA multiples are in part dependent on cheap and abundant debt financing, it is also necessary and appropriate to ask whether the current debt market is sustainable. A reversion to the mean would involve significant (and painful) changes in both valuations and the debt markets.

Concerning the debt markets, interest rates are at historic lows and are being actively managed down by the Federal Reserve, a policy that most believe cannot be sustained indefinitely. If interest rates go back to historic norms, it seems self-evident that leverage multiples must go down. Higher interest expense will make it harder for companies to service their debt. At the margin, for loan quality to stay constant, leverage multiples would have to decline.

Concerning valuations, it seems equally self-evident that if interest rates rise, rational investors will demand higher returns from risky asset classes like private equity (a so-called “equity risk premium”). In order to achieve those higher returns, private equity buyers will have to acquire businesses in the future at lower EBITDA multiples. This, coupled with lower lending multiples, would depress valuations and cause current private equity investments (acquired at today’s nose-bleed multiples) to fall short of targeted returns. This in turn could reduce new investment in the asset class and create additional headwinds as the supply/demand equation changes.  Higher interest rates, lower lending multiples and higher required equity returns could create a perfect storm for private equity.

So What?

For those of you who have not yet stepped off the ledge of your 36^th floor office, keep in mind that this is not all bad. And in many ways, it’s nothing new. The timing of this bout of irrational exuberance is a little inconvenient for us as a new firm, but it is likely to create an equal and opposite reaction in the not too distant future, at which point we will once again be able to make sound investments.

After the fact we will all have the fun of second-guessing the Fed, criticizing the short-sightedness of private equity sponsors and berating our wealth managers. Maybe there will be an entertaining Congressional hearing or two. So we have that to look forward to.

For our part, we will continue to seek diamonds in the rough. They are out there, just harder to find.  (However, if this market persists we may also do a little more fishing this summer.)

 

 

 

Year End Letter 2013

Dear Friends of PPE:

Mike David, Andy Kuhar and I founded Partners Private Equity one year ago.  As we approach our first anniversary, it is appropriate to reflect on the past year and look forward to the future.

There is a local Cleveland mid-day sports radio show that ends every day with a segment in which the hosts ask “Why are you smarter?” (i.e., for having listened to these two morons for your entire lunch hour).

So like the radio sports morons, we ask ourselves, “Why are we smarter?” (i.e., for having worked our tails off to get PPE established over the last year).  Of course, scientific research shows that we are no smarter—indeed, as shown in the chart below, science suggests we are measurably less intelligent than this time last year.

                       

However, with the passage of time we have learned more facts.  Net-net, I believe we are no worse for wear.

So a slightly different form of the question—what have we learned in the past year?

Investment Environment

The investment environment currently is extremely competitive and characterized by a general lack of fear.  There is some ambiguity in the statistics, but we believe private equity valuations are at or near historic highs.  We at PPE are value investors by nature and generally seek opportunity in old economy “story” deals where we can add value by recruiting new management, improving operations or implementing new strategies.  Such deals generally sell at a discount.  However, in the last year we opened files on 84 deals and submitted bids on 25.  We were outbid on most of them—often by a lot.  We don’t have perfect information but we believe that the winning bids were on average approximately 20-25% higher than ours.

This suggests that the “winning” private equity buyers are either (a) making much more heroic assumptions about future earnings growth/valuation multiples than PPE or (b) solving for lower equity returns.  We estimate that at prevailing deal pricing, PE firms may get 12-14% average internal rates of return on their vintage year 2013 equity portfolios (if all goes well).  By contrast, we try to price deals where, with reasonable projection assumptions, we can earn compound equity returns of 20-25%.  We believe these are the appropriate returns for this asset class.  However, our valuation standards have (for the time being) put us at a disadvantage.

Are we right to maintain our valuation discipline?  Studies on crowd behavior suggest that people tend to believe the preponderance of opinion around them.  The preponderance of opinion currently seems to be that asset values are going to go up significantly in dollar terms, at least in the near to intermediate term.  There are a couple of ways this can happen but there are an equal number (if not more) ways that such values could go down.  We try not wring our hands too much over that which is unknowable but we’re sticking to our guns on valuation discipline.

 

Sticking to our Guns

Economic Environment

We try not to invest based on a macro view of the economic environment.  However, we can make some observations about how the overall economic environment colors our investment outlook.

Most significantly, it appears that Mr. Bernanke has succeeded.  The Fed’s quantitative easing policy has achieved its goal of keeping interest rates down and forcing investors back into risk assets (public and private equities, real estate, etc.).  This has pushed stock indexes to record highs and re-inflated the real estate bubble to a significant extent.  Private equity valuations have not been immune—multiples are at or near historic highs.  However, the planned tapering and ultimate withdrawal of quantitative easing presents long term risks for all of these asset classes.   It is likely, for example, that a reversion to long term average interest rates could cause equity values to fall 30% or more, all else being equal.

Overall, the pervasive influence of government in all aspects of our economy—money supply, interest rates, asset values and tax policy—tends to distort  the efficient allocation of capital that has traditionally been a strength of the US economy.  Markets now seem to be significantly more focused on government policy than on economic fundamentals.

Can economic fundamentals catch up to the Potemkin Village economy the Fed has created?  Interestingly, the answer is yes.  Implausible as it may seem, if Congress passes a comprehensive economic reform package—entitlement reform, tax reform, and budget reform—it could put in place a long term solution to the country’s fiscal problems and lay the foundation for decades of growth.  It could happen and the economic implications would be profound.  We are not holding our breath, but we note that the recent Congressional budget deal negotiated by Paul Ryan and Patty Murray is a baby step in the right direction.

However, all of these macro-economic considerations are out of our control and way above our pay grade.  While we don’t craft our investment strategy based on these factors, we try to pay attention so that we don’t blindly get caught up in the madness of crowds and government policymakers.

 

Deals

The deal market often provides insight into sectors of opportunity and risk.  When insiders in a given sector are aggressively selling, it can be a sign that the sector is approaching a peak and is exposed to downside cyclical risks, or that individual companies will not be able to sustain their performance.  We have seen a large number of companies in the market that fit this description.

In many cases, these companies have declining growth rates and unsustainable margins.  Coming out of the recession, many of these companies had pricing power as competitors folded and, with the recovery, have benefitted from significant increases in volume.  As the economy continues to stabilize however, historically high margins will likely be arbitraged away in competitive bidding.  Insiders who perceive these risks are, not surprisingly, motivated to sell.

We have also seen a number of good businesses with sustainable business models and good prospects.  In the last year, many of these sold for high multiples of peak cash flow.  Many of these businesses are cyclical and were financed with significant leverage.  Buyers have to hope that they can get through several years of debt amortization before the next cyclical downturn.  These deals may work out but we don’t believe high prices and excessive leverage represent a sound investment approach long term.

Despite these landmines in the deal environment, we are pursuing a number of interesting opportunities.  As always, an important qualification is that we must acquire these businesses at compelling valuations.  We currently are working on three deals where we have a very good chance of negotiating a letter of intent in the first quarter.

Next Year

We are looking forward to 2014.  We have recently moved into new offices in the Lakepoint office building in Beachwood after spending most of the year subletting from our friends at Kirtland Capital Partners in the same building.  KCP’s partners were tremendously supportive (and surprisingly tolerant).  We deeply appreciate their support at such a critical point in the development of our firm.  We are especially grateful for the adult supervision and TLC provided by KCP’s talented office manager, Diane Johnson.

New Office

 

Our plan for the coming year is to continue to compete hard for deals—especially the more difficult “story” deals where we believe we have a competitive advantage.  We plan to stick to our valuation discipline and focus on companies that are misunderstood and have significant value-creation opportunities.

Happy New Year!

John Mueller                           Michael David                                 Andrew Kuhar