Taking Stock 24 October 2024
Cricket, yachting, netball - and now there is evidence that NZ might be displaying good form in the investment world as well.
While the most credible of financial commentators, The Financial Times, is displaying the woes of the messy Private Equity world, New Zealand continues to display one version of Private Equity that is fundamentally sound.
George, now in his 60s, returned from overseas and founded Direct Capital 30 years ago and has been mostly true to his own rules, at meaningful levels. He identifies about 1000 NZ companies that meet his criteria.
He sought to invest capital into successful, proven private companies, that had existing revenues and profitability each year. He sought to raise funds from only those who had a genuine ability to wait a long time for their funds to be repaid. He did not promise liquidity.
Accordingly he sought and won support from the likes of the Accident Compensation Corporation, later the NZ Government Super Fund, large pension funds, KiwiSaver funds and only those wealthy individuals who were not dependent on liquidity.
George’s model therefore matched his funding with the needs of the private companies he bought.
The result has been fair rewards for risk, for the lack of transparency, and for the forfeiture of liquidity.
He has had some spectacular successes, though perhaps his greatest victory was more akin to shooting fish in a barrel (his “stealing” of Scales remains a scalp that others, not he, facilitated).
Direct Capital helped Ryman Healthcare evolve into a multi-billion dollar company.
Today, Direct Capital is nurturing “Wet and Forget”, the cleaning product that does not feed toxins into our waterways.
And he has a new project underway - possibly land-based - as he prepares to release yet another fund. Details will emerge soon.
I admire and respect the commitment of his team to a set of guidelines that have largely satisfied his clients and kept him free of the ugly scenes now being witnessed globally.
The world now observes that Private Equity as an asset class has several dubious characteristics:
1. It is favoured by fewer and looser regulations, enabling PE managers to be greedier, riskier, and less transparent than public-listed offerings.
2. It is clouded by valuations that are often cynically created, valuers not at arms' length, and often "incentivised" to meet target prices (as we saw with property valuers in the lead-up to the 2008 Global Financial Crisis).
3. It is dependent on low interest rates to fund its long-term investment time frames.
4. It escapes scrutiny because of a generally lower level of public attention and media awareness of its progress. Disclosure is much more optional than is the case with listed securities.
5. It escapes true measurement. How often does one read of the comparison between the exit price achieved and the price implied by previous valuations?
The result globally is now messy.
Private Equity funds are increasingly converting to Private Debt funds as often discussed in Taking Stock. The key to this conversion is again the lower level of regulatory supervision and the absence of capital to back risky loans.
More worryingly, PE funds are finding it harder to achieve an exit, either through public or private sale.
This is evidenced by a sharp increase in the “secondary market,” as pension funds seek to offload their PE assets at a discount, and at a much greater level.
For example, currently there are three trillion US dollars-worth of PE investments, a new record.
In the past 12 months, US$150 billion were sold on the secondary market, an increase of 25% from the previous year.
In 2019 and 2020, 4% and 5% were prematurely exited. In 2023, that figure was 14%.
PE funds are rapidly creating new funds to buy the assets of established funds, to enable the disenchanted to exit. The number of impatient investors seems to be growing.
Indeed, The Financial Times described the growth in secondary market exits as “blistering”.
One large US pension fund manager noted that "we have made many investments over the last 25 years in PE. Unfortunately, a material proportion of them have not liquidated in an orderly fashion so we are taking the position that it might be time to get out through secondary sales".
Taking Stock has for some time pointed out the danger in allowing PE allocations by NZ businesses like KiwiSaver, where there are few with research or analytical experience. I would say the number would be the same if it was doubled, in those cases where the funds invest by rote.
The ACC and the NZ Super Fund, and of course Direct Capital, have highly-paid specialists to enter this market, as does Milford and a small number of other fund managers.
But as the world is now discovering, transparency, valuations established by market transactions, liquidity, and access to expertise have a value, and are prerequisites for successful investing.
Ross George at Direct Capital is to be lauded for building a real value-add model.
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George’s skills in picking out winners and sticking to credible criteria were not the principal reason he had a windfall from his purchase and subsequent sale of Scales, the company the late Allan Hubbard built and today has a market capitalisation of some $557 million.
The gift of taxpayers’ money came after the Key government had acquired Scales via a quite dreadful Crown error leading to false accusations of fraud against Hubbard.
That error dumped Scales into a pot controlled by lazy Treasury executives and a quite dreadful receivership, and led to infantile, self-serving or simply incompetent advice from lawyers and investment bankers. Key failed to act to prevent the plundering of taxpayer money.
The taxpayers should have recovered far more than they paid out under the Crown guarantee scheme, which reimbursed some South Canterbury Finance depositors. Genuine managers of distressed companies, like Duncan Saville, knew that patience would restore hundreds of millions of more value.
But key assets, especially Scales, were flicked off at absurd prices, just as PWC and Hubbard himself had warned.
Scales was sold by the receiver for SCF, advised by drongos, for $44m, less than the dividends it paid over the coming few years.
Direct Capital and the ACC were the opportunists who captured what should have been taxpayers' value and within years flicked it off with a public issue. It was sickening to observe. The SCF story is told in The Billion Dollar Bonfire.
I guess the only good news was that ACC was a beneficiary. It is a Crown entity, so one could argue the Crown "stole" from the Crown.
Had this transaction occurred in Venezuela, South Africa, Russia, or Uganda (under Idi Amin), one might have wondered if it coincided with a shortage of brown paper bags.
Of course it happened in NZ, where there is no corruption, so we can be easily convinced that it was just miserable incompetence that led to the switch of wealth to Direct Capital and ACC.
The other of George’s odd victories was his buying into the troubled empire of the British opportunist, Andrew Barnes, who had hatched a plan with another opportunist, George Kerr, to buy and then merge Perpetual Trust with other trust companies, including NZ Guardian Trust (NZGT).
To me this seemed like buying trams to form a bigger tram company. Trust companies have no real future, in my opinion.
The investment by Barnes would have been of sufficient size to qualify the ex-Macquarie fellow for a special NZ residency, if he had no other natural pathway to permanence in NZ. He bought Perpetual for $14 million and NZGT for $60 million with expensive finance, including mezzanine finance, the most obvious source of loan repayment being a trade sale of the new group or an NZX listing.
The latter never sounded credible to me, given the sector is in its twilight years and is neither especially profitable or able to add value equivalent to its extravagant fees, in my opinion.
The new grouping, then owned by a Barnes entity, struggled to produce the nett sums needed to service the high levels of debt. An ugly outcome seemed to lurk.
A highly improbable offer to buy the group for about $200 million was documented to include a $20 million non-refundable deposit.
Two Australian lads, with not an iota of trust experience, had cobbled together the deposit and duly donated it to Barnes when the frankly absurd offer inevitably fell over.
Subsequently, Direct Capital stepped in with the clout to add more time for a new resolution, and eventually sold and profited nicely, basically leaving the bulk of the group in the hands of Barnes and now a lawyer, who switched career to be a trust company CEO.
The new group makes a modest profit - a few million - and would face issues if it employed investment staff that won the attention of the big boys in capital markets, who pay big numbers to capture any highly talented analysts. Talent does not head to trust companies very often, for obvious reasons.
Direct Capital's in-and-out role with Barnes' entity was profitable but not consistent with the criteria George espouses when he invests in growing companies with long-term prospects of greater market share and greater profitability.
There are, of course, other examples of Private Equity success. Rangatira, bred from the McKenzie family, has had some victories, as have one or two of the funds run by Lance Wiggs and others run by former Goldman Sachs investors.
On the other side, we have had Powerhouse, a quite disgraceful group created by some impecunious Brits who had neither the wit, nor the substance, to convert a credible idea into financial success.
Powerhouse Ventures had a deal with Canterbury University to help new companies grow, and may prefer to be labelled a “venture capital” firm that has performed dreadfully, rather than a Private Equity fund that has failed.
The difference between Private Equity and Venture Capital is not insignificant but for retail investors whose only investment is via their pension funds, the difference is barely relevant.
Both types of funds seek to employ skilled people able to sort the most promising from the mundane or the improbable.
Direct Capital, under George, has been the best of the best, notwithstanding his oddball exceptions.
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A constant theme in Taking Stock for some decades has been the absurdity of solving over-indebtedness by borrowing more.
This week, the International Monetary Fund has called for immediate action to reduce global debt.
Here is why:
The world’s indebtedness (as a percentage of GDP) has grown by 90% since 2000 and is projected to keep growing from the current scarcely believable total debt figure of US$100 trillion.
The US debt level will reach high into the clouds, but the G7 countries will not be far behind, both heading for 200% of GDP. Japan is destined to hit 325%, Italy and France heading to 150%.
Notably cautious is Germany, where it is expected to fall to 40% of GDP. Its economy is very likely to be in recession, with minimal improvement over the next two years.
It continues to baffle mathematicians that as the world is wallowing in conflict, with human and asset destruction and wanton waste of resources, financial markets hit record heights, cheered by the ability to borrow ever more, at lower costs.
No doubt Trev and John Clarke have the answers.
The world does not know how lucky "we are". We can all borrow more!
Next up the Trump election.
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Travel
I am giving a talk to a group in Arrowtown on November 14 and would enjoy meeting individually with clients before the 3.30 pm meeting. I have some available times in the afternoon.
Our advisers will be in the following locations on the dates below:
1 November – Lower Hutt – Fraser Hunter8 November – New Plymouth – David Colman13 November – Ellerslie – Edward Lee14 November – Albany – Edward Lee15 November – Auckland CBD – Edward Lee14 November – Arrowtown – Chris Lee28 November – Napier – Edward Lee29 November – Napier – Edward Lee
Please contact us if you would like to make an appointment to see any of our advisers.
Chris Lee
Chris Lee and Partners Limited
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