December 12, 2022 – One of the more amusing aspects of getting older is becoming a proponent of the dad joke.
These jokes are cheesy, sometimes clever, and will most likely make you groan or potentially feel embarrassed for the purveyor. I came across one that made me snicker just the other day (bare with me!).
Sorry, I couldn’t help it.
As a game favoured by babies, peekaboo’s core activity involves the adult covering their eyes, pretending they cannot be seen, only to reveal them to the soon-to-be giggling baby.
Peekaboo serves as an apt analogy for private market investing, in which giggling allocators have the volatility of their investments covered from their view by mark-to-model accounting.
This analogy was recently tabled in an article in which The Economist asks, Has private equity avoided the asset-price crash?:
“Babies lacking object permanence—the understanding that things they cannot see continue to exist—love the game of peekaboo. An adult hides their face from sight, then suddenly comes back into view, prompting squeals of delight. Grown-ups no longer enjoy being deceived—unless they invest in private equity and venture capital, where hiding bad news is part of the fun.”
Many market prognosticators have posited that the main appeal of private markets is its “volatility smoothing” nature, given private assets do not get marked-to-market and therefore do not showcase the same volatility as liquid stocks and bonds.
Of course, the volatility smoothing of private assets is a ruse. Just because an asset is not publicly traded, does not mean it has lower volatility or reduced risk.
For example, a portfolio of commercial real estate assets will exhibit the same risk and volatility whether they exist in a public REIT or a private one. The vessel in which the assets reside has no bearing on the underlying assets’ risk and return characteristics.
Nonetheless, there is something to be said regarding the benefits of private asset mark-to-model accounting. From an allocator’s perspective, the volatility laundering of private assets lowers career risk, because impairments of private assets can either take years to manifest or reverse in due course. This career risk mitigation needs to be balanced against liquidity needs because, by definition, private assets typically cannot be sold readily (or at a good price).
The Economist continues its skepticism around private asset valuations: “The gulf in valuations cannot be justified on economic grounds. All firms face the same toxic cocktail of slowing growth, rising interest rates and stubborn inflation. If anything, private ones, often more leveraged, should be more exposed when credit tightens. Instead the gap is mostly an illusion rooted in the peculiarities of private investing. One is well known. While public markets are constantly repriced in full view of the world’s investors, shares in private firms are traded far more rarely and opaquely… Less appreciated is the array of tricks private funds use to smooth out returns. Many keep their valuation-work in house: a 2015 survey by Grant Thornton, a consultancy, found that only around a quarter of them sought an independent opinion on the growth and discount rates they use in their models. That gives managers the discretion to make assumptions that flatter the prospects of the firms they own.”
The public markets can be unforgiving, but they keep managers honest. It is difficult to trust a private fund’s performance when the manager can choose the fund’s performance themselves, especially when comparable public assets are falling precipitously.
This mark-to-pretend accounting of private funds brings us to one of the most interesting dynamics encapsulating the dichotomy between public and private valuations of comparable assets.
Source: Econompic / Accelerate
Through October 31, the largest private REIT was up 9.3% in 2022 while the All Equity REITs index of publicly traded property funds was down 25.5%, according to the Wall Street Journal.
This gulf between lofty and unrealistic private market valuations and the “real” mark-to-market prices of similar public assets has reached its breaking point. There are cracks in the façade of private funds and investors in these private strategies now face a major risk of write-downs.
The major risk for private fund non-redeemers is the payout to redeemers at over-inflated NAVs will reduce the remaining NAV for those who stayed in. This creates a “bank run” dynamic as investors rush to redeem before the private fund’s assets are depleted. Here is how the math would work if 20% of unitholders redeemed while the NAV was marked 33% too high:
The notion that private funds are completely isolated from market forces and related volatility is a charade that is now falling apart, posing material risks to investors caught in these funds.
Investors are starting to catch on to the inflated NAVs and unrealistic performance associated with many private REITs and private debt funds. They are demanding their money back in record numbers, seeking to capitalize on private overvaluations to invest in realistically priced (cheaper) public REITs.
Source: Wall Street Journal
It is not surprising that investors are discovering the risks related to holding these products and seeking to exit all at once. Just this week another large private REIT gated (halted) investor redemptions.
Lack of liquidity is the dark side of private asset investing. Liquidity is like oxygen – it’s not that big of a deal unless you’re not getting it.
Unless these private REITs take material write-downs and reprice their valuations to realistic levels, investors who do not redeem face a significant risk of depleted NAVs as the majority of the value goes to the early redeemers. Those who get out first get the best price, while those who do not redeem are left holding the bag.
The dynamic is analogous to exotic credit products such as mortgage-backed securities and collateralized debt obligations in the mid-2000’s. These exotic credit products burned investors reaching for yield with toxic exposure to unhealthy subprime mortgages that subsequently blew up. Illiquidity combined with a lack of transparency and unrealistic expectations is a dangerous cocktail for an investor. The true underlying values of these toxic and illiquid credit products did not come to light until it was too late.
Those who got out of subprime mortgage exposures before 2007 dodged a massive calamity and major write-downs related to the investment products. As they say, “history doesn’t repeat, but it sure does rhyme” and investors allocated to private REIT and private credit strategies may be facing the same risk as subprime mortgage exposures fifteen years ago. Get out while you still can.
Even if these private funds don’t blow up and torch investor portfolios with large NAV write-downs, a switch trade could make sense.
For example, imagine that two residential condo buildings were available for investment. One trades in the private market at a valuation determined by the hopelessly conflicted management company, while the other trades on the stock market at a price determined by the ever-discerning market. Last year, shares in both the privately-traded property and the publicly-traded one were at $100. This year, there has been a recession and interest rates have risen markedly, hurting property prices and bond values. The publicly-traded property’s share price reflects this reality, with its shares now trading at $70. Oddly, the shares of the private-traded property, as evaluated by management, still trade at $100. Which would you prefer to buy?
If you held the private property shares and could sell them at $100 to buy the publicly-listed shares of an equivalent asset at $70, would this not be a rational switch trade?
Accelerate’s ONEC invests in both private credit and real estate, but in liquid form (via alternative ETFs). ONEC’s mortgage and loan ETFs are down approximately -10% this year while its real estate ETF is down about -20%. This performance reflects accurate, real-time market pricing. To claim positive performance for the asset class if it isn’t traded on an exchange is misleading at best. In any event, if a private fund allows one to get out at an inflated NAV, then take the money.
Selling one asset for $100 and buying the equivalent asset, in a different package, at $70 is one of the best no-brainer arbitrage opportunities I have seen in a while.
This compelling potential arbitrage opportunity has fallen into the laps of private REIT and private debt fund investors. Allocators would be prudent to capitalize on it if the private funds still allow (and do not halt redemptions). Irrespective of the lucrative arbitrage opportunity between lofty private market valuations and more accurately priced public comparables, the prospect of future write-downs and potential gating of funds should be enough to give allocators pause.
Not all private REITs and private debt funds mismark their portfolios. However, an allocator should be hyper-vigilant given the risks in the private asset space. Always demand full transparency and complete a full due diligence process on the underlying assets. If the portfolio disclosure is unclear or the valuations seem to not reflect the current economic environment, pass on the opportunity. When investing in private assets, exercise extreme caution. Trust, but verify.
The performance of alternative investments in 2022 showcases that private funds are not needed to generate positive returns while stocks and bonds are down double-digits. For example, Accelerate’s hedge fund ETFs have positive performance year-to-date on average. Some of our peers’ products, including managed futures and market-neutral equity strategies, have also performed very well. Most importantly, liquid alternative funds have net asset values that are accurately marked on a daily basis by independent third-party custodians (Accelerate uses RBC for its hedge fund ETFs). That way, investors know the pricing is always accurate and their investment is always liquid.
As problems begin to emerge in the private fund space, liquid alternatives, and their investor-friendly characteristics, will continue to shine even brighter.
Accelerate manages five alternative ETFs, each with a specific mandate:
- Accelerate Arbitrage Fund (TSX: ARB): SPAC and merger arbitrage
- Accelerate Absolute Return Hedge Fund (TSX: HDGE): Long-short equity
- Accelerate OneChoice Alternative Portfolio ETF (TSX; ONEC): Alternatives portfolio solution
- Accelerate Enhanced Canadian Benchmark Alternative Fund (TSX: ATSX): Buffered index
- Accelerate Carbon-Negative Bitcoin ETF (TSX: ABTC): Eco-friendly bitcoin
ARB fell -0.4% last month. Comparatively, the benchmark S&P 500 Merger Arbitrage Index total return dropped -1.9% in November and is down -4.9% year-to-date.
The monthly decline was led by the Fund’s position in Rogers Corporation, whose acquisition by DuPont was unexpectedly terminated. In last month’s Merger Monitor, I reflected on the situation, “DuPont was historically known as a highly credible buyer, however, it chose to shred its reputation instead of working through the deal. It appears to be a penny-wise, pound-foolish strategy that will likely eliminate their potential for any future deals.”
Thankfully, we significantly reduced the Fund’s Rogers position in the summer for risk management purposes as the deal was unexpectedly delayed. Unfortunately, we did not completely eliminate the position. This mistake cost the Fund a 90bps loss.
On average, ARB has had about two deal breaks per year since its inception. Rogers was the first one of 2022. Historically, ARB has also had the same corresponding number of bidding wars/increased M&A bids in the Fund, whose gains typically offset losses from the deal breaks. Alas, with the negative market environment, no bidding wars or increased bids have occurred this year.
Some successful deal closures, including the Tenneco and Zendesk buyouts, along with a slight tightening of SPAC arbitrage spreads, added 50bps to ARB’s performance in November and partially mitigated the effect of the Rogers termination.
HDGE gained 2.9% in November as the majority of long-short factors generated positive performance over the month.
In the U.S. long-short book, the quality and value portfolios led the pack as undervalued longs gained 5.0% while overvalued shorts fell -2.4%. High-quality longs gained 6.5% while low-quality shorts lost -2.1%. All five major U.S. long-short factors generated alpha last month.
Canadian multi-factor performance was mixed, with value and price momentum long-short factors notching gains of nearly 3% while the quality and trend long-short portfolios fell -4.8% and -8.0% respectively.
As interest rates normalize and quantitative easing runs its course, we expect stocks to continue to revert back to historical relationships. For example, we have seen overvalued, bubble stocks fall precipitously, and undervalued, boring stocks rally. However, pricing discrepancies between glamour stocks and value stocks still remain at extreme levels despite the positive mean reversion over the past two years. In addition, high-quality stocks still appear to be generally mispriced by the market while some low-quality junk stocks have significantly more market value to lose over the coming years (meme stocks are still a thing).
While the outperformance of long-short multi-factor portfolios has been significant over the past two years, there is nothing we see currently that makes us think this will end any time soon. We continue to believe that undervalued will outperform overvalued, high-quality will outperform low-quality, positive momentum will outperform negative momentum, and favourable trend will outperform unfavourable trend.
ONEC bounced back with a 1.8% gain in November with the majority of alternative investment allocations experiencing positive results.
Risk parity led the pack with an 8.1% return. The real estate, infrastructure, and gold allocations all generated returns above 5% for the month.
Enhanced long-short and absolute returns strategies increased 3.1% and 2.9%, respectively, while the mortgage portfolio gained 2.3% and leveraged loans ticked up 1.0%.
Performance detractors in November included arbitrage, down just -0.4%, and bitcoin, which fell more than -13% due to the fallout of the bankruptcy of crypto exchange FTX.
In November, ATSX gained 3.1% while the TSX 60 total return gained 5.6%. ATSX is up 0.9% while its benchmark is down -0.9% in 2022.
The Fund’s long-short overlay portfolio generated -2.5% of negative performance as the Canadian multi-factor portfolios struggled.
Specifically, the Fund’s short position in negative trending stocks jumped 11.3% while the long positive trend portfolio gained just 3.3%. In addition, low-quality Canadian stocks outperformed their high-quality brethren by 4.8% during the month, as the low-quality shorts gained 8.5% while the high-quality lagged with a 3.7% return.
Have questions about Accelerate’s investment strategies? Click below to book a call with me:
Disclaimer: This distribution does not constitute investment, legal or tax advice. Data provided in this distribution should not be viewed as a recommendation or solicitation of an offer to buy or sell any securities or investment strategies. The information in this distribution is based on current market conditions and may fluctuate and change in the future. No representation or warranty, expressed or implied, is made on behalf of Accelerate Financial Technologies Inc. (“Accelerate”) as to the accuracy or completeness of the information contained herein. Accelerate does not accept any liability for any direct, indirect or consequential loss or damage suffered by any person as a result of relying on all or any part of this research and any liability is expressly disclaimed. Past performance is not indicative of future results. Visit www.AccelerateShares.com for more information.