Recommended
Recommended
More Related Content
Similar to America is in the grips of a speculative frenzy. Investment .docx
Similar to America is in the grips of a speculative frenzy. Investment .docx (19)
More from greg1eden90113
More from greg1eden90113 (20)
Recently uploaded
Recently uploaded (20)
America is in the grips of a speculative frenzy. Investment .docx
- 1. A merica is in the grips of a speculative frenzy. Investment bankers, private investment firms, and even a few dozen recently graduated MBAs labelling themselves “searchers” are calling, emailing, wining, and dining small business owners. Their goal is to translate prosaic small businesses into the poetry of private equity. The great postcrisis private equity gold rush is on, fueled by cheap debt and enthusiastic investors. A lawn care chain might get half a dozen calls and emails a week from business brokers and “searchers.” A regional bank auctioning off a business with $15 million in profits might pitch two hundred prospects, receive fifty letters of intent, and take twelve separate private equity firms to management meetings, ending in a sale price which the majority of bidders considers crazy. And the greatest prize of all—a software company—could sell for many multiples of revenue, regardless of profitability. As with the mortgage-backed securities bubble, experts are the promoters and pioneers of an “asset class” that they claim will offer high returns
- 2. with low risk, guided by the sage wisdom of elite managers. The legendary leader of Yale University’s endowment, David Swensen, has gone so far as to call private equity a “superior form of capitalism.” The experts agree with Swensen. A recent survey of institutional investors found that 49 percent expect private equity (PE) to outperform the public equity market by a whopping 4 percent per year or more. Another 45 percent believe PE will outperform by 2–4 percent per year. Only 6 percent think returns will be comparable. The survey did not even bother to ask if investors thought PE might underperform. This is particularly shocking given that data from Cambridge Associates shows that private equity returns have lagged the Russell 2000 index by 1 percent and the S&P 500 by 1.5 percent per year over the past five years. This consensus has led institutional investors to flood private markets with capital, about $200 billion per year of new commitments. The result is soaring prices for private companies of all shapes and sizes. Just before the financial crisis, in 2007, the average purchase price for a PE deal was 8.9x EBITDA (earnings before interest, taxes, depreciation, and amortization—a commonly used measure of cash profitability). Deal prices reached
- 3. 8.9x again in 2013 and are now up to nearly 11x EBITDA. But asset prices are going up everywhere. What makes private equity dangerous is the use of debt—and the use of phony accounting to conceal the riskiness of these leveraged bets. The average PE deal is 65 percent debt financed, and whereas the valuations of public equities are determined by transparent, liquid public markets, PE firms determine the valuations of their own portfolio companies. Unsurprisingly, they report far lower volatility than public markets. This appraisal accounting also encourages lenders to take risks. After the financial crisis, the Federal Reserve warned banks that most companies could not bear debt above 6x EBITDA. Lenders now tend to stop at 6x EBITDA in keeping with that rule, but they allow PE firms to play with the definition of EBITDA. Whereas regulators require public companies to use GAAP financials, lenders allow PE firms to remove various “one-time” costs to get to “pro forma” EBITDA or to take a particularly positive recent quarter and extrapolate from that short time period to an optimistic “run-rate” calculation. Such optimistic metrics are at their most extreme in software, where lenders will finance companies based on neologisms
- 4. like “annual recurring revenue” and “cash EBITDA,” which, having no fixed definition, allow debt levels to be picked from the air. In 2007, private equity debt levels reached 5.2x EBITDA. Today, they are at 5.8x EBITDA, and they have been above 5.2x every year since 2013. The 2007 vintage deals did not end well for investors. Today’s higher-priced and more leveraged deals could end even worse. These levels of leverage leave companies with no margin of safety. Most companies’ cash flows are too volatile and unpredictable to sustain high debt levels for long. In addition, the recent tax reform caps interest deductibility at 30 percent of EBITDA, which for most firms translates to about 5x EBITDA of debt. This will be particularly problematic for highly leveraged firms, especially in any downturn when EBITDA declines. Those that are February 20, 2018 Private Equity: Overvalued and Overrated? by Daniel Rasmussen https://americanaffairsjournal.org/ https://americanaffairsjournal.org/author/daniel-rasmussen/ lucky enough to grow will be fine, but companies with large
- 5. interest payments and looming debt maturities cannot invest for growth. The history of financial markets echoes with a warning: beware markets where investors are not only bullish but also borrowers. Yet there is always a logic behind each bubble, a set of ideas that form the foundation of the consensus thinking. And there are three premises that underlie the private equity boom. First, the experts believe that PE firms make money by improving the companies they buy. Second, the experts believe that PE is less volatile and less risky than public equity. Third, the experts believe that PE will significantly outperform every other investment. There is near complete consensus on these three points among academics, investors, and PE firms. Private equity assets today exceed $2 trillion, and PE firms have $700 billion of dry powder capital just sitting there, waiting to be invested. The market is so flooded with investors and valuations are so high that even the truest believers have not found a way to invest it. There is a huge amount of money betting that this consensus is right, and the voices arguing that the consensus is wrong are marginal relative to the chorus of
- 6. those who agree. But what does the data show? Is there evidence supporting these three core hypotheses? Or could some of the world’s best and brightest all be betting on the same hollow assumptions? Let’s investigate each of these hypotheses in turn. Do Private Equity Firms Improve Companies’ Operations? At the peak of the private equity boom in early 2007, Cerberus Capital Management announced that it was buying Chrysler from DaimlerChrysler for $7.4 billion. The New York Times described Cerberus as a “private equity firm that specializes in restructuring troubled companies.” “As a private company, Chrysler will be better positioned to focus on its long-term plan for recovery, rather than just short-term results,” Chrysler’s chief executive, Thomas W. LaSorda, told the Times. Conventional wisdom had it that the sharp businessmen at Cerberus could slash costs and return Chrysler to growth. After taking the company private, they could then take the difficult steps necessary to transform it. A mere two years later, however, the company filed for Chapter 11 bankruptcy. The turnaround had failed. The financial crisis had sent the
- 7. company into a tailspin, and Cerberus was derided for its very public failure. Many critics of PE tell stories like this to demonstrate the rapaciousness of PE capitalism—the hubris before the fall, the stripping of assets, the inevitable bankruptcy. But what is more interesting is what it reveals about the narrative of operational improvement. The Chrysler deal is one obvious case study that points to the fact that private equity’s operational savvy is not always as impressive as claimed in marketing materials. PE firms relentlessly promote the idea that they can restructure companies and orient them toward long-term growth rather than short-term results. Blackstone, the PE giant, advertises on its website that it makes money “by investing in great businesses where our capital, strategic insight, global relationships, and operational support can drive transformation and realize the company’s potential. The resulting improvements in growth and global competitiveness benefit not only investors, but also workers, communities, and all stakeholders.” And at some level, this makes sense. Why would Blackstone buy the entire company instead of just a minority stake? Presumably because they think they can run the business better than the current management team.
- 8. But do PE firms truly improve growth and competitiveness? What impact do these firms really have on the businesses in which they invest? This might seem like an unanswerable question. After all, PE firms take their companies private, hiding their financials from the public. The industry would have us believe that the proof is in the pudding: their return outperformance proves they are better managers who drive superior growth and produce superior outcomes. But there is, actually, a way to answer this question. As it turns out, many PE firms issue debt to finance acquisitions and, in those cases, the firms are required to provide investors with the company’s financials. These financials can be used to compare a company’s pre- and post-acquisition performance to determine exactly what the PE firms achieve. My firm, Verdad, took that information and compiled a comprehensive database of 390 deals, accounting for over $700 billion in enterprise value (EV), a substantial set of data representing the majority of the largest deals ever done. We then analyzed it to understand what has actually been going on in the PE industry.
- 9. We wanted to put each of the industry’s core claims to the test. Firms like Blackstone often claim that their portfolio companies will achieve accelerated growth and more efficient operations, because of a superior capital structure and PE managers’ ability to make long-term investment decisions that public companies may not be able to make. If these claims are true, we should see results in the financials of the portfolio companies, such as accelerated revenue growth, expanded profit margins, and increased capital expenditures. But the reality is that we see none of these things. What we do see is a sharp increase in debt. In 54 percent of the transactions we examined, revenue growth slowed. In 45 percent, margins contracted. And in 55 percent, capex spending as a percentage of sales declined. Most private equity firms are cutting long-term investments, not increasing them, resulting in slower growth, not faster growth. If PE firms are not growing businesses faster, investing more in growth, or gaining much operational efficiency, just what are they doing? In 70 percent of cases, PE firms are leveraging up the businesses they buy. PE firms typically double the amount of debt on the balance sheet,
- 10. from 2.5x EBITDA to 5x EBITDA—the biggest financial change apparent from our study. The industry mythology of savvy and efficient managers streamlining operations and directing strategy to increase growth just isn’t supported by data. Instead, there is a new paradigm for understanding the PE model—and it is very, very simple. As an industry, PE firms take control of businesses to increase debt and redirect spending from capital expenditures and other forms of investment toward paying down that debt. As a result, or in tandem, the growth of the business slows. That is a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management. That is not to say that debt is always bad, or that rerouting capital to debt paydown is necessarily a negative thing. There is an optimal capital structure for every company that maximizes the value of the interest tax shield while minimizing the risks of financial distress. Many companies have too little leverage. The effective use of leverage was key to private equity’s historical success. In the 1980s and early 1990s, private equity firms helped rein in the impulses of would-be empire builders and bad capital allocators (Japan today could probably use a
- 11. healthy dose of this, for example). Investors were right to demand earnings not be kept in the business but instead returned to investors through debt paydown and dividends. But there is a big difference—bigger than most realize— between what private equity used to do (buy companies at 6–8x EBITDA with a reasonable 3– 4x EBITDA of debt) and what private equity does today (buy companies at 10–11x EBITDA with a dangerous 6–7x unadjusted EBITDA of debt). Debt is a double-edged sword. It can provide great benefits if used judiciously, but if regularly applied in large dollops, it can create massive problems. The PE industry has created an effective and pervasive marketing myth: that they are superior to individual companies’ management, operating more efficiently and earning greater returns. But, as we have seen, this is largely fiction. The real reason PE firms want control of the companies they buy is not because of superior strategic insight but because they want to significantly increase debt levels. And while debt magnifies positive returns and enhances the returns of good decision-making, it can also cut the other way, exacerbating negative returns and punishing bad
- 12. decisions. My firm’s study is not the only one to come to this conclusion. A 2013 study of 317 LBOs by researchers at the University of Texas found “little evidence of operating improvements subsequent to an LBO. . . . Our results suggest that effecting a sustained change in capital structure is a conscious objective of the LBO structure.” Bain & Company’s 2017 global private equity report came to similar conclusions. They compared deal model forecasts for revenue and EBITDA with the results for PE deals in their proprietary database. More than two-thirds of the time, PE deals underperformed the EBITDA forecasts made at the time of purchase. This underperformance was masked, however, by almost two turns of multiple expansion at sale. “GPs [private equity fund managers] had the good fortune to make up the shortfall in margin expansion through unforeseen multiple expansion,” Bain wrote. The evidence suggests that operational improvements are more marketing than reality. Does Private Equity Offer Lower Risk? Risk and return are generally related, and financial products that offer high returns at a low risk are likely to deliver on neither promise.
- 13. Daniel Kahneman and Amos Tversky found that humans are twice as sensitive to losses as they are to gains. They call this cognitive bias “loss aversion.” The public equity markets are very volatile—a difficult thing for the loss averse to stomach. The volatility of public markets has consistently puzzled academics since the 1930s. John Burr Williams, who invented modern finance theory, wished for a day when experts would set security prices. He believed that expert valuations would result in “fairer, steadier prices for the investing public.” The PE industry would seem to have made Williams’s dreams come true. Experts, rather than markets, determine the prices of PE-owned companies. Even better, those experts are the PE firms’ employees! Predictably, this results in dramatically lower volatility. The hurly burly of the public markets is replaced by the considered judgment of an accounting firm that just so happens to be employed by the PE fund. Investors have seen how those types of cozy relationships worked out in the past.
- 14. To understand the magnitude of this difference, consider what happened in 2014 and 2015 when energy prices crashed over 50 percent. The S&P 600 Energy Index dropped 52 percent during the period from December 31, 2012, to September 30, 2015. Yet at September 30, 2015, PE energy funds from the 2011 vintage were actually marked up on average to 1.1x multiple of money invested (MoM), while funds from the 2012 vintage were marked at 1.0x MoM and 2013 vintage funds were marked at 0.8x MoM. PE energy funds almost universally claimed to have dramatically outperformed the public equity market, not even recognizing half of the losses exhibited in public markets. Institutional investors value these “smoothing effects,” as they call them. In a recorded public presentation, the CIO of the Public Employee Retirement System of Idaho called this the “phony happiness” of private equity. “We did know that our actuaries and accountants would accept the smoothing that the accounting would do. It may be phony happiness, but we just want to think we are happy,” he said. “If [private equity] just gave public market returns, we’d be in favor of it because it has some smoothing effects on both reported and actual risks.”
- 15. In other words, the Public Employee Retirement System of Idaho is allocating more capital to the asset class not in order to make the public employees of Idaho more money but because the CIO of the system values the “phony happiness” of the smoothed accounting. George Washington University professor Kyle Welch argues in a recent paper on PE accounting, “Private Equity’s Diversification Illusion,” that portfolio managers “have incentives to obfuscate systematic risk and to choose investments that appear low-risk.” If public markets take a dive, portfolio managers with large PE holdings might not have to book large losses. Welch shows that if PE firms adopted fair value accounting standards, then the reported volatility of private equity would double. We can also see this in the PE secondary market, where investors trade their stakes in different PE funds. Marking the reported returns of private equity to market by using these secondary transactions would bring the volatility of private equity higher than the public markets. Market pricing demonstrates that private equity is far riskier than internal valuation marks suggest. For example, PE funds traded at 59 percent of their net asset value (NAV) at the depths of the financial crisis
- 16. when bought by PE secondary firms; the internal marks, in other words, were far from the actual transaction values. But is this smoothing so bad if everything comes out right in the end? That is what some PE investors argue. And to the extent that things do come out right in the end, reducing a few wiggles along the way really is not so problematic. But not seeing the wiggles can also encourage complacency, allowing valuations and leverage levels to climb and climb because the consequences of those decisions have not yet been felt. A lack of short-term accountability just means a delayed reckoning, with all the chips coming due down the road. And there are warning signs that all might not end up so well. Does Private Equity Offer the Best Returns? Over a long horizon, private equity has certainly had a good run. From 1990 to 2010, private equity returned 14.4 percent per year, compared to 8.1 percent per year for the S&P 500 index. This 6.3 percent outperformance was net of private equity’s “2 and 20” fee structure, meaning that the gross return of private equity over this period was more like 20 percent per year.
- 17. But past performance is a far worse predictor of future returns than prices. And as money has flooded into private equity, the prices paid for PE assets have gone up and up. In 2007, the average purchase price for a PE deal was 8.9x EBITDA. Deal prices reached 8.9x again in 2013 and are now nearing 11x EBITDA. In fact, private market valuations have been equal to or greater than public market valuations since 2010. As noted earlier, since 2010, private equity has, on average, underperformed the public equity market. Cambridge Associates’ U.S. private equity index has lagged the Russell 2000 by 1 percent and the S&P 500 by 1.5 percent per year over the past five years. Institutional investors’ expectations for PE returns seem rooted in the asset class’s performance in the 1980s, 1990s, and early 2000s. They have not adjusted for the recent period’s underperformance—an underperformance caused by their invested capital driving up purchase prices. The underperformance since 2010 shows that private equity does not always outperform public equity markets. The relative performance of private equity is contingent on size, leverage, and valuation. The Canadian Pension Plan Investment Board (CPPIB) and the
- 18. Abu Dhabi Investment Authority (ADIA) did a bottom-up analysis of 3,492 private equity transactions from 1993 to 2014 to understand these dynamics. They found that private equity deals are different on two key quantitative dimensions from public equity investments. First, PE firms buy companies that are significantly smaller than broader public benchmarks. The median market capitalization of a company in the S&P 500 is $41 billion. The median market capitalization of a small-cap company in the Russell 2000 is $2 billion. But the median enterprise value of PE deals is only $250 million. Only about fifteen private equity investments have ever been larger than the maximum market capitalization of the small-cap index. Second, PE deals are significantly more levered than the typical public equity. The CPPIB and ADIA found that the average ratio of net debt to enterprise value at inception has been approximately 65 percent. The typical Russell 2000 small-cap company is levered at about 16 percent while the median large-cap company in the S&P 500 is levered at about 18 percent. These two factors have been basically constant since the early 1980s. Changes in deal size and deal leverage levels do not
- 19. explain why performance relative to public equity markets dropped off after 2010. And differences in size and leverage explain only about 50 percent of private equity’s historical outperformance of public equity markets. The factor that has changed is valuation. Private equity firms have historically bought companies at much lower valuations than the broader public markets. Here we see a significant shift from before the financial crisis to after. Since the crisis, the flood of money into private equity has driven up purchase prices significantly, eliminating the formerly large gap between private and public market valuations. This is more troubling than most market observers understand. Private equity is price sensitive because of the use of debt. Higher prices require more debt, leading to higher interest costs and higher risk of bankruptcy. The importance of valuation to returns is controversial but key to understanding the asset class, so it is worth looking at the issue from a few different angles. The first approach is to look at PE deals and compare returns to purchase price. One PE firm did just such an analysis and found that over 50
- 20. percent of deals done at valuations of more than 10x EBITDA lost money and that the aggregate multiple of money was barely over 1.0x (i.e., for every dollar invested, only slightly more than one dollar was returned to investors). The second is to compare the average purchase multiple in a given year to the returns of the funds from that vintage year. There is a –69 percent correlation between purchase price and vintage year return, a strong inverse relationship. The third is to look at PE-backed companies that IPO. My firm, Verdad, looked at every company taken public in the United States and Canada by a top-100 PE firm since the financial crisis, a data set of 195 IPOs with an aggregate EBITDA of $66 billion and an aggregate market capitalization of $728 billion. The average company in this data set went public with $4 billion in market capitalization, traded for 17x EBITDA, and was 21 percent leveraged on a net debt/enterprise value basis at IPO. We segmented these IPOs by valuation at IPO. We divided the universe into three buckets: companies that went public at less than 10x EBITDA (about 20 percent of companies), 10–15x EBITDA (about 20 percent of companies), and more
- 21. than 15x EBITDA (about 60 percent of companies). According to our research, the cheaper IPOs dramatically outperformed the Russell 2000, the moderately priced IPOs matched the Russell 2000’s return, and the expensive IPOs underperformed. The fourth approach is to listen to what PE firms are saying themselves. PE executives surveyed by Preqin said their biggest challenge was valuations (their second biggest challenge, worrisomely, was the “exit environment”). Joe Baratta, Blackstone’s global head of private equity, said “this is the most difficult period we’ve ever experienced. . . . You have historically high multiples of cash flows, low yields. I’ve never seen it in my career. It’s the most treacherous moment.” Despite considering it a difficult period to invest, Blackstone Capital Partners VII raised $18 billion in 2015, the largest fund it had ever raised. Whether you look at PE deals or public equity investments, paying high prices for companies and using debt to fund the purchase looks like a bad strategy. The scary thing is that private equity purchase multiples passed 10x in 2015 and show no signs of going down. In our view, the 2015, 2016, and 2017 vintage years are likely to return close to zero percent per year if history is a good guide.
- 22. Broader Implications Private equity does not always outperform the public equity markets. The major change that PE firms make to portfolio companies is the addition of debt, not magical operational transformation. And the valuation marks which suggest that the volatility of private equity is lower than that of public equity are based on the subjective opinions of the PE firms themselves—hardly an unbiased source. Yet the consensus thinking among institutional investors is leading them to shift money from public equity markets (which they consider overpriced and overly volatile) into private equity markets. But does this shift of capital from public to private make sense? David Swensen, Yale’s chief investment officer, believes it does. He contrasts the “short-termism” of public equity markets with the “five- to seven- year time horizon” of private equity. In his thinking, when you have PE firms acting as “hands-on operators that are going to improve the quality of the companies, there’s no pressure for quarter-to-quarter performance.” This is a traditional criticism of big public companies: they have no real “owner” who looks after the long-term health of the firm or holds managers accountable. Instead, the CEOs respond to the whims
- 23. and vagaries of a shareholder base that is either dispersed and inattentive or overly focused on short-term movements in the stock price. PE firms, by contrast, are supposed to “think like owners,” making the tough choices that are best for the company in the long run. But the evidence shows that PE firms are really just adding debt: the supposed improvement in incentives and managerial alignment is more marketing than substance. To be sure, debt can have a disciplining effect, and can enhance returns on good investments. But the amount of debt being used in most buyout transactions today has gone way too far. And debt, as Clay Christensen has pointed out, reduces a company’s long- term capital flexibility. The “discipline of debt” and “long-term thinking” are mutually exclusive goals. And it is of course ironic that the same PE firms making these arguments—Blackstone, KKR, Apollo— have themselves gone public. When institutional investors criticize the “short-termism” of public equity markets, perhaps they are really critiquing the transparency of market valuations. The internet and big data have made the inability of most investors to beat the public equity index much more obvious, leading to the
- 24. rise of passive, low-cost index investing. Perhaps it is no surprise then that highly paid investment managers prefer to move money into private markets, where the numbers are fuzzier and where it takes years rather than minutes for the consequences of bad decisions to be realized. So PE firms end up adding debt in hopes of enhancing returns and using phony accounting to conceal volatility. And the institutional investors that have flooded private equity with capital prefer this “phony happiness” because it reduces career risk and the hard work of having to explain the volatility of public markets to stakeholders. Gold Rushes Past and Present The California gold rush of 1849 was led by individual speculators who dreamed of newfound wealth. The great private equity gold rush of the postcrisis era, like the subprime bubble before it, is led by managers and consultants, whose spreadsheets are well formatted and precisely wrong. The California gold rush of 1849 was based on the discovery of actual gold in streams and mountains. The great private equity gold rush of the postcrisis era is based on airy ideas about operational improvements, low volatility, and historical outperformance.
- 25. They may not be tangible, but they make for good bullets in a PowerPoint presentation. The California gold rush of 1849 did not end well for the poor and desperate speculators who dreamed of a better future. And the great private equity gold rush of the postcrisis era may not end well for the confident experts who deploy other people’s capital with the goal of staying rich, not getting rich—and it may be even worse for everyone else. How much has private equity contributed to the bizarre economic situation of recent years—in which asset prices soar while underlying GDP, along with productivity growth, remains historically weak? And is today’s private equity froth a warning sign of the next crisis? This article originally appeared in American Affairs Volume II, Number 1 (Spring 2018): 3–16. This article reprint is an independent publication and the views, opinions, predications and any past performance and/or returns cited in the article by the author do not represent the experience of any individual investor. The writer(s) are third parties who are not affiliated with or in any way related to Penn Capital Management Company, Inc. (“Penn Capital”), its portfolio
- 26. managers, employees or affiliates. This document is provided as a convenience and for informational purposes only and Penn Capital is not in any way responsible for the content of the document. Penn Capital shall not be deemed to endorse, recommend, approve, guarantee or introduce any third parties or the services/products they provide or to have any form of co-operation with such third parties unless otherwise stated by Penn Capital. Nothing presented herein should be construed as an offer or invitation to sell or any solicitation of any offer or invitation to buy securities or other financial instruments, or any advice or recommendation with respect to securities or other financial instruments. Your use of this document and information contained therein is at your own risk and Penn Capital is not responsible for any damages or losses incurred or suffered by you arising out of or in connection with your use of the document or its contents. Contact the external writer(s) for answers to questions regarding its content. Before acting on any advice, opinions or recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional investment advice. The potential for profit is accompanied by the possibility of loss.
- 27. Blank Page For Institutional Investor Use Only – Not for use with retail investors. Active Microcap - A Private Equity Alternative September 2017 Introduction Over the last few decades the assets allocated to private equity strategies have increased significantly. What began as a strategy primarily utilized by large and sophisticated endowments increasingly became more prominent in public plans, corporate plans, and even among high net worth investors. An era of budgetary setbacks and increased funding requirements pushed more plan sponsors to seek private equity’s historically high absolute returns as a means of alleviating funding challenges. Unfortunately, private equity has failed to deliver the expected returns in more recent history. Additionally, private equity strategies come with several risks and challenges, including less transparency, limited liquidity, and higher fees. Compounding the challenges, effective investing in private equity requires additional expertise and
- 28. resources that can be difficult to come by. Given the additional hurdles and risks involved in investing in private equity, it should be expected that private equity would provide a meaningful return premium over public equities. Unfortunately, for many investors that outperformance has not been realized. On the other hand, we believe microcap stocks share many of the similar return advantages that make private equity appealing to investors, but without most of the associated risks. Microcap stocks are underfollowed by institutional investors and sell side brokers, making the microcap space an attractive place for active managers to be able to generate strong returns. In fact, active microcap managers invest in many of the same stocks that private equity managers target. Given the comparable return patterns that active microcap managers have delivered, along with significantly fewer risks than private equity, we think active microcap provides an appealing alternative to private equity. Active Microcap as a Proxy for Private Equity – Similar Historical Returns For many years investors that were early to embrace private equity were rewarded with appealing returns. Many of the early adopters were large endowments with absolute return investment policies. Over time private equity has received increasing allocations from public and corporate pension plans, resulting in large
- 29. flows into private equity. As a result, private equity returns have not held up against those delivered by public equity in recent periods. We believe one of the difficulties that private equity has faced in recent history is overcrowding, with too much money competing for too few attractive investment opportunities. This has left large amounts of capital on the sidelines and the net effect 2 has been a deterioration of returns relative to public equity markets. Given that private equity returns have not compensated investors for the additional risks inherent in private equity investments in recent years, institutional investors have sought alternatives. From an asset class perspective, we believe that microcap is the market segment that most closely mirrors private equity. However, we believe it is active microcap managers that offer an investment experience most similar to private equity, more specifically capturing the return advantages, while avoiding the associated risks. Over the long run, active microcap managers have had long- term returns that rival private equity returns and beat passive benchmarks, both large and small. Additionally, as we have noted in Exhibit 1, over the majority of time periods,
- 30. active microcap investors have outperformed private equity as well as the passive indexes. The return patterns of active microcap managers tend to be highly correlated to those of private equity managers due to the similar characteristics of companies that microcap and private equity managers seek. Exhibit 1: Public vs. Private Equity Returns, Net of Fee (Annualized through 12/31/2016) Source: Acuitas, Cambridge Associates, FTSE Russell, eVestment Alliance, FactSet Private Equity returns are reported by Cambridge Associates net of management fee. Active Micro returns assume an estimated 1% annual management fee. The inception of the Russell Microcap Index is 2001. Passive Micro/Small Cap uses the Russell 2000 Index for periods prior to 2001. 0% 2% 4% 6% 8% 10%
- 31. 12% 14% 16% 18% 5 Years 10 Years 15 Years 20 Years 25 Years Passive Large Passive Small Passive Micro Private Equity Active Micro 3 Microcap and Private Equity Offer Similar Return Patterns In addition to providing absolute returns that are most comparable to private equity over the long-term, active microcap managers also tend to deliver a return pattern that is most similar to private equity. In the chart below (Exhibit 2) we have demonstrated that the investments trend in the same direction and enjoy similar periods of difficulty and success. The primary differences between the two return series are a function of peaks and valleys. This apparent lower volatility of the private equity returns is misleading, as it can be mostly explained by the infrequent and stale pricing in the asset class, self-reporting of returns, and survivorship bias. Conversely, microcap stocks are priced every day. Importantly,
- 32. while private equity doesn’t appear to experience the same level of volatility as microcap, the returns are still highly correlated. Exhibit 2: Quarterly Returns of Private Equity vs. Active Micro (1Q 1991 to 4Q 2016) Source: Acuitas, Cambridge Associates, FTSE Russell, FactSet -30% -20% -10% 0% 10% 20% 30% 40% Private Equity Active Micro 4
- 33. Microcap and Private Equity Managers Seek Similar Investment Characteristics One reason that active microcap returns most closely mirror private equity is that microcap and private equity investors naturally tend to buy similar companies. Most notably, private equity managers target small, niche companies like those found in microcap. Like private equity, an active microcap product can offer a concentrated, high- conviction portfolio from an inefficient, minimally researched pool of companies with meaningful return potential. Additionally, they share many beliefs about what makes an attractive investment. Active microcap managers as a group tend to favor strong cash generation, limited leverage, and stable business fundamentals; all characteristics that private equity managers favor as well. Many stocks active microcap managers target also tend to be inexpensive based on valuation metrics that private equity general partners use to value companies, such as EV/EBITDA. Additionally, it is important to note that both asset classes have been beneficiaries of the flood of capital into private equity. As private equity allocations have increased, private equity investors are seeing more competition for their target companies, resulting in higher purchase prices. According to Bain & Company in their 2017 Global Private Equity Report, ”Capital superabundance and the tide of recent exits drove dry powder to yet another record high in 2016.” Active microcap managers who
- 34. owned stocks that are targeted by acquirers have benefitted from the higher prices paid by investors. As we outline below, merger and acquisition activity has been a meaningful boost to returns in microcap. Asset allocators have historically expected private equity to generate returns of 3% – 5% over public equity, net of fees. What investors often overlook is the existence of a return premium in microcap. Between July 31, 2011 and December 31, 2016, according to FactSet, there have been over 500 mergers and acquisitions of companies below $500 million in market cap. Exhibit 3 shows the number of takeouts within a variety of market cap buckets. Of course, there are more securities in the smallest market cap buckets, so the larger number of takeouts on an absolute basis is to be expected. That said, as the table below demonstrates, when we compare the total takeouts in each market cap group (over the same 7/31/11 – 12/31/16 time frame) to the total number of securities in the Russell 3000E Index (as of 12/31/16), it is clear that microcap stocks are acquired more frequently.
- 35. 5 Exhibit 3: Completed and Pending Mergers/Acquisitions by Market Capitalization (7/31/2011 – 12/31/2016) Source: Acuitas, FactSet. Percentages in the table are based on the total number of takeouts between 7/31/2011 and 12/31/2016 relative to the total number of securities for the corresponding market cap bucket within the Russell 3000E Index as of 12/31/2016. In addition to the increased frequency of takeouts within the microcap space, the premiums paid tend to be meaningfully larger as well. This is particularly true for those companies below $250 million in market cap, where the 30-day premium has averaged nearly 52% from July 31, 2011 through December 31, 2016.
- 36. 0 50 100 150 200 250 300 350 400 450 25m - 250m 50% 250m - 500m 32% 500m - 750m 26% 750m - 1b 32% 1 - 1.5b 22% 1.5b - 2b 26%
- 37. 2b - 3b 23% 3b - 4b 22% 7/31/11 - 12/31/16 Takeouts as a % of Securities in the Russell 3000E Index (12/31/2016) 6 Exhibit 4: Merger/Acquisition Premiums by Market Capitalization (7/31/2011 – 12/31/2016) Source: Acuitas, FactSet. Active Microcap Avoids Risks Associated with Private Equity There are many risks and unique challenges inherent in private equity investing that a microcap allocation allows investors to avoid. Most notable of these are the lack of liquidity, transparency, flexibility, and accessibility. Additionally, private equity managers charge significantly higher fees than microcap managers. While each of these are factors that drive investors to demand significant return premiums for private equity investments over public equities, the flood of capital into private equity and a limited opportunity set is
- 38. diluting the return opportunity and pushing out the investment horizon. On the liquidity continuum, microcap sits somewhere between very liquid large cap stocks and very illiquid private equity investments. Some of the return similarities could be attributed to the expected liquidity premiums in private equity and microcap. However, the liquidity benefit from microcap is significant relative to private equity. Sizeable microcap portfolios can be invested in a matter of days or weeks, usually with no lockup, while private equity portfolios take years to get fully invested and can have lockups of up to a decade or more. The liquidity difference allows investors the flexibility to adjust asset allocations to microcap over time, to raise capital when needed, and to upgrade their portfolios to keep them invested in their highest confidence investments. The long-term 0% 10% 20% 30% 40% 50% 60%
- 39. One Day Premium (%) Five Days Premium (%) 30 Days Premium (%) 7 returns of private equity do not show a return premium commensurate with the illiquidity of the investment as the asset class has underperformed active microcap on an annualized basis over the past 25 years. Furthermore, most active microcap mandates offer transparency into the underlying portfolios, including the holdings, transactions, and risk characteristics. Investors are able to discuss the investment process with the manager, and gain insights into when and why managers make portfolio investments. This is not the case with many private equity allocations. Historical Success - Realized Private Equity Returns Vary Less tangible, but equally important to having success in private equity is whether investors have skill at identifying strong private equity managers. Specialized experience, strong networks, and access to the best private equity managers are critical drivers of successful investment in private equity. These characteristics are what can differentiate successful private equity investors from those that deliver mediocre or poor returns. In
- 40. Josh Kosman’s book “The Buyout of America”, David Thomas, a Managing Partner of Court Square Capital Partners, said “The reason everyone focuses on top quartile is because if you are in the high end of the second quartile, you might as well be in bonds. And if you are in the middle or low end of the second quartile, you might as well be in a CD. And anything below that [median/50 percent] and you are losing money." A study by Lerner, Schoar, and Wong (2005) attempted to identify success characteristics for various subsets of private equity investors, While the study is admittedly dated, it identified an interesting dynamic. It found that between 1991 and 2001 endowments earned an average of 20.5% in their private equity portfolios, while public pensions and corporate pensions earned 7.6% and 5.1%, respectively. This supports the idea that endowments, as the early wide-scale adopters of private equity, were able to build up superior expertise, experience, and networks that led to success in private equity. It is difficult for newer entrants to replicate the level of skill those institutions have, particularly in today’s crowded private equity space. We think organizations that have developed superior skill in private equity investing can still have success in private equity, but it has become increasingly difficult for most institutions to develop the skill necessary. Microcap is a Sensible Choice for Uncalled Capital
- 41. A final point to make about the potential value of microcap as a proxy for private equity is as a placeholder for uncalled capital. Often there is a significant lag between the commitment of capital in private equity investments and the time the capital is called. The liquidity of microcap makes it a flexible investment that can serve as a long-term strategic allocation or a short-term proxy. In a 2010 paper on microcap, Allianz suggested that (depending on a plan’s ability to meet capital calls in the event of a decline) “due to the lengthy vesting period [of private equity], a sensible choice may be to temporarily invest 8 idle, committed but not called capital in a micro-cap strategy.” We concur with this assessment. For plans that desire a similar return pattern to private equity with the benefit of greater liquidity, we believe microcap makes a reasonable temporary investment. Of course, investors must assess their ability to meet capital calls in the event of a decline in the market. But since capital can sit idle for long periods of time, we feel that active microcap provides the best proxy for private equity returns while keeping the investor’s asset allocation closest to its target. Summary
- 42. We believe that an allocation to active microcap has a place for both investors making a strategic allocation as well as investors using it as a temporary proxy for private equity. Active microcap managers have generated similar returns, in terms of absolute returns and return patterns, to private equity, but at significantly less risk and costs. Many of the advantages of private equity, such as the ability of skilled managers to generate strong returns through concentrated positions in high confidence investments, can be found with greater liquidity, transparency, and flexibility in active microcap investing. Additionally, there are reasons to believe that it has become increasingly difficult to replicate the private equity returns of the past, including the large amounts of assets that have flown to private equity funds, and the difficulty of organizations to build the skills necessary to be successful in private equity investing. Meanwhile, active microcap stocks and managers are positioned to be beneficiaries of the large amount of private equity competing for potential investments. As such, we think for most investors an allocation to active microcap has better chances of long-term success at lower levels of risk than private equity. 9
- 43. References Bain & Company, “Global Private Equity Report.” 2017 Bruce Grantier, InvestorLit Research, “Private Equity vs. Public Equity.” November 2013 Allianz Global Investors Capital, “Micro-Cap Investing: A Suitable Alternative to Private Equity.” 2010. Bruce Grantier, “Is Small Cap a Viable Alternative to U.S. Private Equity?” April 2009. Zhiwu Chen, Roger Ibbotson, Wendy Hu, “Liquidity as an Investment Style.” September 2010. Kosman, Josh, “The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis.” 2009 Lerner, Schoar, and Wong, “Smart Institutions, Foolish Choices? The Limited Partner Performance Puzzle.” 2005 Disclosures Past performance is not a guarantee of future results. This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation or solicitation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not
- 44. be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Investing in Today’s Economic Climate Presented by: Eric Green, CFA , Director of Research, Senior Portfolio Manager, Senior Managing Partner February 4, 2019 For educational use only. Not for distribution to, or for use with, individual investors. Agenda 1. Penn Capital Introduction 2. Outlook for Equity, High Yield, and Commodities 3. Interest Rates and Inflation
- 45. 4. The Case for Small Cap Equities 1 Section 1 Penn Capital Introduction 2 Mr. Green began his career at Penn Capital in July 1997. As Director of Research, Mr. Green is responsible for guiding the firm’s day-to-day investment research process. He also serves as the Portfolio Manager for Penn Capital’s Small Cap, Smaller Companies Growth, and Mid Cap equity strategies as well as chairing the Penn Capital Equity Strategy Committee. Throughout his career, Mr. Green has focused on the energy, media, gaming, and leisure industries. He is a member of the firm’s Executive Committee which drives overall strategy and management of the firm. Prior to joining Penn Capital, Mr. Green gained experience with the Federal National Mortgage Association, the Royal Bank of Scotland, and the United States Securities and Exchange Commission where he served as a financial analyst in the Division of
- 46. Investment Management. Mr. Green is also Vice Chairman of the Board of Directors for the Anti-Defamation League (ADL), Mid-Atlantic Region and Co-Chairman of the ADL's 2018 Walk Against Hate. He received a BSBA, Cum Laude, from American University and received an MBA from the Yale School of Management. Bio 3 Client Allocation (%) Public 31% Commingled 17% Taft-Hartley 13% WRAP/Model Delivery 13% Retirement/Other 8% Sub-Advisory 8% Corporate 7% Non-Profit 2% Insurance 1%
- 47. Firm Overview High Yield Credit $1.7b† Defensive Floating Rate Income $120** Defensive Short Duration High Yield $266 Defensive High Yield $969 Opportunistic High Yield $277 Customized Solution s $46 Equity $1.2b Micro Cap $198 Smaller Companies Growth $70 Small Cap $658 Small to Mid Cap (SMID) $167
- 48. Mid Cap $61 Total Assets Under Management $2.9b* (as of 12/31/2018) AUM Allocation (%) Credit Strategies 59% Multi-Credit 41% Dedicated Bond 14% Dedicated Loans 4% Equity Strategies 41% *AUM includes non-discretionary assets associated with model delivery accounts **$160m total loans held. † Includes over $335m invested in Socially Responsible Investing (SRI) Penn Capital Facts Independently Owned, Investment-Driven Culture • Founded in 1987; Headquartered in Philadelphia • 58 total employees; 27 partners
- 49. • Investment Driven – 23 member investment team • Institutionally focused Specialists in Capital Structure Investing • Fully integrated credit and equity investment team • Fundamental, bottom-up proprietary research process • Over 1,000 company management meetings per year Investment Philosophy and Characteristics • High Conviction – High active share • Capacity Constraints – Liquidity advantage and style integrity • Client Focused – Partnership in developing custom solutions Investment Vehicle Availability • Institutional Mutual Funds • Institutional Limited Partnership • Institutional Separate Accounts 4 Targeting Optimal Capital Structure Catalysts We believe greater investment returns can be achieved by
- 50. identifying companies moving toward their Optimal Capital Structure For illustrative purposes only Under-levered Over-levered Leverage Multiple Optimal Capital Structure S to c k P ri c e Inflection Point
- 51. Leveraging Improvements Earnings potential Growth initiatives Financing flexibility De-leveraging Improvements Market sentiment Credit rating upgrade Access to capital markets Optimal Characteristics Balance sheet fundamentals Weighted average cost of capital Efficient market pricing Investment Process and Philosophy 5 Case for a Private Equity Approach to Public Market
- 52. For illustrative purposes only Debt Catalyst Targeting • Debt catalysts can provide leading indicators to equity value in periods of low market clarity • Debt analysis requires a differentiated skillset, enhances research complexity, and is rarely performed by equity managers • Private equity approach to public market utilizes size, free cash flow, and debt catalyst factors to enhance and optimize growth Warning Signs Approaching Maturity Wall Lack of Liquidity Covenant Breaches Deteriorating Cashflow
- 53. Credit Downgrade Unintentional Leveraging Positive Catalysts Deleveraging Leveraged Recap Refinancing Improving Free Cashflow Credit Rating Upgrade Discounted Bond Purchases Higher Stock Prices and Higher Multiples Lower Stock Prices and Lower Multiples
- 54. Case for a Private Equity Approach to the Public Market 6 De-leveraging Opportunities Enhance Enterprise Value Enterprise value is defined as the market value of the equity plus the par value of the debt minus cash. Our enterprise value focus allows us to view every opportunity like a private equity investor Leveraged Capital Structure 60% Debt 40% Equity 40% Debt 60% Equity Low Leverage
- 55. Capital Structure 20% Debt 80% Equity Deleveraging: As companies pay down debt and enterprise value remains constant, equity value increases Lower Leverage: With less perceived risk, equity value and enterprise value increase Enterprise Value: (Market Value of Equity + Par Value of Debt) – Cash At this stage a company becomes a very attractive private equity investment as it is under-levered and has demonstrated its ability to reduce debt. Debt Value Equity Value Additional Enterprise Value Potential Equity ValueDebt Value
- 56. Debt Value Equity Value Additional Enterprise Value Potential Case for a Private Equity Approach to the Public Market 7 Section 2 Outlook for Equity, High Yield, and Commodities 8 Corporate and high yield sectors tend to be more sensitive to improving credit and economic conditions which typically coincide with rate increases.
- 57. Periods of Rising 10 Yr. Treasury Rates *Periods over one year are annualized -5.01 1.14 -13.72 -4.51 -1.20 2.03 -3.15 1.15 10.85 6.66 2.92
- 59. 10 15 October 1993 to January 1995 5.34% to 7.60% (+2.26%) June 2003 to June 2006 3.43% to 5.11% (+1.68%) May 2013 to December 2013 1.66% to 3.04% (+1.38%) July 2016 to Sept 2018 1.49% - 3.05% (+1.56%) P e rf o rm a
- 60. n c e ( % )* US 10 Yr Treasuries Investment Grade Bonds Bank Loans Short Duration BB-B HY 1-3 Yr Bonds High Yield Bonds Interest Rate Sensitivity As of 9/30/2018. FOR ILLUSTRATIVE PURPOSES ONLY. Source: Morningstar Direct, Credit Suisse. Indices used: ICE
- 61. BofA Merrill Lynch US Treasury 10 Yr+, ICE BofA Merrill Lynch US Corporate Master, Credit Suisse Leveraged Loan, ICE BofA Merrill Lynch US HY BB-B 1-3Yr. *Periods over one year are annualized. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. Indices are unmanaged and not available for direct investment. Past performance is no guarantee of future results. 9 -250 100 450 800 1,150 1,500
- 84. 18 3 Year Forward Annualized Returns Nov-00 Jun-02 Mar-08 July-08 Sept-11 Feb-16 Russell 2000 Index 8.50% 12.81% 8.57% 5.18% 21.26% N/A 5 Year Forward Annualized Returns Nov-00 Jun-02 Mar-08 July-08 Sept-11 Feb-16 Russell 2000 Index 10.12% 13.88% 8.24% 9.45% 15.82% N/A Mar 2008 Nov 2000 June 2002 Sep 2011 Feb 2016 July 2008 IC E
- 86. n st ra in e d In d e x S p re a d s Spreads Over 800: Forward Equity Returns
- 87. As of 12/31/18. Source: Morningstar Direct. Past performance is no guarantee of future results. Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. 10 Chart112/1/19961/31/19972/28/19973/31/19974/30/19975/31/19 976/30/19977/31/19978/31/19979/30/199710/31/199711/30/199 712/31/19971/31/19982/28/19983/31/19984/30/19985/31/19986/ 30/19987/31/19988/31/19989/30/199810/31/199811/30/199812/ 31/19981/31/19992/28/19993/31/19994/30/19995/31/19996/30/1 9997/31/19998/31/19999/30/199910/31/199911/30/199912/31/1 9991/31/20002/29/20003/31/20004/30/20005/31/20006/30/2000 7/31/20008/31/20009/30/200010/31/200011/30/200012/31/2000 1/31/20012/28/20013/31/20014/30/20015/31/20016/30/20017/31 /20018/31/20019/30/200110/31/200111/30/200112/31/20011/31/ 20022/28/20023/31/20024/30/20025/31/20026/30/20027/31/200 28/31/20029/30/200210/31/200211/30/200212/31/20021/31/200 32/28/20033/31/20034/30/20035/31/20036/30/20037/31/20038/3 1/20039/30/200310/31/200311/30/200312/31/20031/31/20042/2
- 90. 595 652 544 566 560 521 519 476 475 487 466 490 507 513 491 476 487 508 575 588 616 617 626 643 677
- 92. 883 890 829 838 772 644 679 613 567 546 551 473 448 418 405 434 441 391 428 410 402 406 383 363 317
- 93. 310 329 283 352 419 413 385 330 366 354 361 367 371 342 337 313 304 312 335 345 349 344 329 320 289
- 96. 477 476 509 542 558 730 841 707 779 723 661 598 599 604 696 644 616 598 574 563 565 534 495 498 486
- 97. 455 462 521 471 478 483 436 427 400 421 381 377 371 367 353 404 384 440 430 467 504 526 446 482 459
- 98. 458 500 536 570 662 590 640 695 777 775 705 621 597 621 569 510 497 491 467 422 400 374 392 381 374
- 102. 736112/31/20173631/31/20183292/28/20183473/31/20183724/3 0/20183465/31/20183636/30/20183717/31/20183468/31/201834 99/30/201832810/31/201838111/30/201842912/31/2018472 B: Bonds U: Utilities R: REITs S: Staples T: Telecom What was once safe, may now be risky 11 -12x -10x -8x -6x
- 105. 16 20 17 20 18 P/E Russell 2000 Cyclical Sectors (Left) P/E Russell 2000 Defensive Sectors (Left) P/E Difference (Right) Cyclical vs Defensive Sector -2x -1x 0x 1x 2x 3x
- 108. 20 17 20 18 P/E Russell 2000 Small Cap (Left) P/E Russell Top 200 Large Cap (Left) P/E Difference (Right) Small Cap vs Large Cap -16x -14x -12x -10x -8x -6x -4x
- 111. 20 17 20 18 P/E Russell 2000 Top Leverage Quintile (Left) P/E Russell 2000 Bottom Leverage Quintile (Left) P/E Difference (Right) High Leverage vs Low Leverage P/ E vs H is to ri c A
- 113. to ri c A vg -10.8% +10.7% -20% -10% 0% 10% 20% Small Cap Large Cap P /E v s
- 121. (N TM ) R at io Cyclical, Small Cap, and Leverage Factors at Historically Low Relative Valuations As of December 31, 2018. P/E calculated using current price and NTM earnings. Source: FactSet. Cyclical Sectors: Consumer Discretionary, Energy, Financials, Industrials, Technology, Defensive Sectors: Consumer Staples, Health Care, Real Estate, Telecommunications, Utilities. Russell 2000 Leverage Quintile calculated by Debt / Capitalization Ratio. Leveraged index returns are ex Financial sector due to greater usage and unique balance sheet treatment/utilization of debt from other sectors. Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. Past
- 122. performance is no guarantee of future results. 12 • Federal Reserve Policy • US-China Trade Deal • US Government Shutdown/Reopen • Worldwide Economic Growth or Lack of Growth • US Slowdown in earnings growth • Oil Prices 6 Major Issues Impacting Markets 13
- 123. • Supply and demand is balancing for crude oil in the US and around the world • Worldwide demand increasing about 1 – 1.5 million barrels per day • Depletion is about 3 million barrels per day • Capital expenditures for exploration and production companies are down more than 50% • Over $300 billion in projects have been cancelled or postponed through 2020 • OPEC has prevented the market from balancing earlier • Original goal was to recapture market share • Huge financial pain experienced by OPEC members during this low price environment • Saudi Arabia reverses stance and needs to stabilize market for Aramco IPO • Cut production in late November; this will speed up balancing
- 124. of the market • Marginal barrel of oil costs at least $65-70 per barrel Oil and the Energy Sector 14 Section 3 Interest Rates and Inflation: What is the outlook for each and how will they affect other investments? 15 Equity Performance During Rising Rate Environments Past performance is no guarantee of future results. Sources: Morningstar Direct. Indices are unmanaged and not available for direct investment. Index
- 125. comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. Rising Rate Periods 10Y Treasury Rate (%) Annualized Returns (%) Start Date End Date Duration (Months) Starting Rate Ending Rate Change (bps) BbgBarc Agg Bond Index S&P 500 Index
- 126. Russell 2000 Index Oct-98 to Jan-00 16 4.42 6.67 +225 -0.61 28.32 27.85 Jun-03 to May-06 36 3.35 5.11 +176 1.91 11.64 19.16 Dec-08 to Apr-10 17 2.96 3.66 +70 9.01 24.77 36.10 Jul-12 to Dec-13 18 1.66 3.01 +135 -0.17 25.30 30.35 Sept-17 to Sep-18 13 2.12 3.05 +93 -1.56 18.64 20.54 Historical Periods of Rising Rates -0.61 1.91 9.01 -0.17 -1.56
- 128. 20 30 40 Oct 1998 to Jan 2000 Jun 2003 to May 2006 Dec 2008 to Apr 2010 Jul 2012 to Dec 2013 Sept 2017 to Sep 2018 BbgBarc Agg Bond Index S&P 500 Index Russell 2000 Index P e rf o rm a n c e (
- 129. % ) 16 No bubble compared to past periods of excess… • Low quality non-refinance issuance has remained relatively low. • Majority of issuance continues to be used for debt refinancing which enables companies to lock in low rates for extended periods of time. • Refinance amounts are expected to remain above our 40% alert level as companies anticipate higher rates in the future. • Speculative issuance for acquisitions is on the rise but mostly for strategic acquisitions which are often accompanied by equity issuance.
- 130. • 2018 is on track to use the fourth most amount of equity for M&A since 2000. 2014-2015 represented a post-2000 high in the amount of equity used for acquisitions. • M&A expected to continue to pick up, but we expect high yield companies to be net beneficiaries of acquisition activity. • LBO issuance has been moderate in the bond market but rising in the loan market, which bears watching. Source: JP Morgan, Bloomberg. Graphs as of December 31, 2018. The red lines illustrated in the charts above represent Penn Capital’s internal alert level for these data points. The gold bars indicate those that breach, or are close to, the alert level. The blue bars represent those that do not. Lower rated new issuance includes bonds rated Split-B or lower. 39% 37%
- 131. 41% 46% 0% 3% 4% 3% 16% 26% 29% 22% 22% 28% 27% 13% 15% 16% 30% 38% 44%
- 140. 17 2 0 18 Acquisition Financing/LBO as a Percent of Total Issuance 1.8% 1.9% 2.7% 3.6% 0.9% 1.0% 0.1% 0.1% 0.5% 1.7% 1.3% 2.7%
- 147. 2 0 16 2 0 17 2 0 18 Lower Rated New-Issue Volume, Excluding Refinancings Aggressive issuance from 1996 to 1999 accounted for 7.9% of 1998's year-end market size Aggressive issuance from 2004 to 2007 accounts for 10.3% of 2007's year-end market size
- 148. 46% 54% 50% 41% 91% 70% 73% 72% 50% 45% 44% 53% 50% 48% 34% 78% 77% 75% 57%
- 157. 2 0 17 2 0 18 Refinancing as a Percent of Total Issuance Issuance Trends – No bubble compared to period of excess 17 0 250 500 750
- 159. 12% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 JP Morgan 12 Month US Default Rate (Left) High Yield Spread (Right) As of December 31, 2018. Source: BoA Merrill Lynch, JP Morgan High Yield Spreads vs. Default Rate 18 Section 4 The Case for Small Cap Equities 19
- 160. • Active portfolio management can add value. • A greater percentage of return comes from stock selection factors instead of style or industry. • Consolidation and regulatory pressures have reduced analyst coverage in the Small Cap space leading to less efficient markets. • A reduction in active market makers has made the market less liquid and capacity more important. • Publicly traded Small Cap equities are attractive Mergers & Acquisitions (M&A) targets. • Small Cap equities offer the opportunity for higher active share ratios. • Better diversification and lower correlation relative to other key asset classes.
- 161. The Small Cap Advantage 20 What is the current “Small Cap” definition: • The definition of Small Cap can vary by index provider, but it is generally a company with a market capitalization of between $300 million and $3 billion • The largest stock in the CRSP index is $9 billion in market cap • Micro Cap stocks are typically between $300 to $500 million How does the industry define Small Cap? 21CRSP: Center for Research in Security Prices 1992 2018
- 162. IPO – June 26, 1992 Market Capitalization $273 Million SBUX: $85 Billion 12/31/2018 SMALL CAP INVESTING IS FOCUSED ON THE FIRST 2X- 15X IN APPRECIATION $ Why invest in Small Cap equity stocks? 22 Event/Trend Consequence Large Caps Small
- 163. Caps Sarbanes Oxley Changed compensation incentives and Central Bank Policies - QE The Federal Reserve and other Central Demographics Baby boomers started retiring and Global Market Volatility Flight to Safety –
- 164. Growth of Passive Investments Capitalization based indexes expanded Factors driving Large Cap’s performance advantage over Small Cap’s since 2006 may be ending… 23 Year Russell 1000 (%) Russell 2000 (%) Calendar year performance difference LC-SC 1995 37.77 28.45 9.32 1996 22.45 16.49 5.96 1997 32.85 22.36 10.49 1998 27.02 -2.55 29.57
- 165. 1999 20.91 21.26 -0.35 2000 -7.79 -3.02 -4.77 2001 -12.45 2.49 -14.94 2002 -21.65 -20.48 -1.17 2003 29.89 47.25 -17.36 2004 11.40 18.33 -6.93 2005 6.27 4.55 1.72 2006 15.46 18.37 -2.91 2007 5.77 -1.57 7.34 2008 -37.60 -33.79 -3.81 2009 28.43 27.17 1.26 2010 16.10 26.85 -10.75
- 166. 2011 1.50 -4.18 5.68 2012 16.42 16.35 0.07 2013 33.11 38.82 -5.71 2014 13.24 4.89 8.35 2015 0.92 -4.41 5.33 2016 12.05 21.31 -9.26 2017 21.69 14.65 7.04 2018 -4.78 -11.01 6.23 R1000 R2000 The Russell 1000 (large cap) and 2000 (small cap) indices have roughly split leadership with Large Caps outperforming Small Caps in 13 of the past 24 calendar years.
- 167. Each asset class experienced periods of consecutive calendar year out-performance. The next cycle could favor Small Cap investing Past performance is no guarantee of future results. Sources: Morningstar Direct. Indices are unmanaged and not available for direct investment. Index comparisons have limitations because indexes have volatility and other material characteristics that may differ from a particular investment. 24 • The “Size Effect” is real and obtainable, but it requires a long-term perspective. • Small Cap stocks offer structural advantages that are only increasing with the impact of various trends like increased regulation, lowest interest rates and overvalued large cap stock prices. • The next cycle could substantially favor Small Cap stocks,
- 168. but it is important to access investment strategies focused on real value or opportunities in the market. Conclusion 25 26 • Questions • Case Studies • New ideas/Favorite Ideas This document has been prepared solely for informational purposes. The information presented herein is not to be used or considered as an offer or invitation to sell or issue or any solicitation of any offer or invitation to buy securities or other financial instruments, or any advice or recommendation with respect to such securities or other
- 169. financial instruments. No information is warranted or guaranteed by Penn Capital or its affiliates as to its completeness, accuracy, or fitness for a particular purpose, express or implied. Information presented is subject to change at any time due to market, economic, regulatory or other changes. Any comments or statements made herein may reflect the opinions or commentary of the person(s) who prepared them, and therefore may not necessarily reflect those of Penn Capital. Penn Capital may have issued, and may in the future issue, other communications that are inconsistent with, and reach different conclusions from, the information presented herein. Those communications reflect the assumptions, views, and analytical methods of the person(s) that prepared them. These materials are not intended for distribution to or use by, any person or entity who is a citizen or resident of or located in any jurisdiction where such distribution, publication, availability or use would be contrary to law or regulation or which would subject Penn Capital to any registration or licensing requirement within such jurisdiction. To the extent permitted by applicable law, Penn Capital accepts no liability for any loss arising from the use of the material presented herein. Penn Capital may, to the extent permitted by law, act upon or use the information or opinions presented herein, or the research or analysis on which they are based.
- 170. The contents may not be reproduced in whole or in part or otherwise made available without the prior written consent of Penn Capital. Disclosure 27 Furey Research Partners, LLC does not guarantee the accuracy or completeness of this report, nor does Furey Research Partners, LLC assume any liability for any loss that may result from reliance by any person upon such information. The information and opinions contained herein are subject to change without notice and are for general information only. This research is for our clients only. Any unauthorized use or disclosure is prohibited. Receipt and viewing of this research report constitutes your agreement not to redistribute, retransmit or disclose to others the contents, opinions, conclusion or information contained in this report.
- 171. This research is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. We seek to update our research as appropriate, but various factors, including regulatory restrictions, may prevent us from doing so. Our reports may be published at irregular intervals as appropriate in the analyst's judgment. Opinions expressed herein reflect the opinion of Furey Research and are subject to change without notice. This research is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objectives, financial situations or needs of individual clients. Furey Research, its employees and affiliates are not responsible for any investment decision. Clients should consider whether any advice or recommendation in this research is suitable for their particular circumstances and, if appropriate, seek
- 172. professional advice, including tax advice. The price and value of the investments referred to in this research and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed and a loss of original capital may occur. Certain transactions, including those involving futures, options and other derivatives, give rise to substantial risk and are not suitable for all investors. Fluctuations in exchange rates and other economic factors could have adverse effects on the value or price of, or income derived from, certain investments. Small and micro capitalization securities are often more volatile, less predictable and involve higher risk levels than large capitalization securities. This report is generally targeted toward sophisticated institutional investors who can understand the risks associated with such investments. Copyright ©2016 Furey Research Partners, LLC. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written
- 173. consent of Furey Research Partners, LLC. Disclosure – Furey Research Partners 28