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August 21st, 2020

Weapons of Math Destruction

Before technology permitted us to feed parking meters with credit cards, customers had to use quarters. If you arrived at a meter without change, one would walk into a nearby store and ask for change for a dollar resulting in four quarters being returned to you. This exchange is exactly the math of a stock split where the price post split should be exactly correlated with the split ratio so the cumulative value of your stock position should remain unaltered. However, recent stock splits belie the underlying stock split math. Tesla announced a 5/1 split several days ago. It was greeted by a market reaction akin to the founding of a new, great religion. In the absence of any new information on Tesla, other than the split, its market value increased by over $100 Billion in a few days. This value increase exceeds the cumulative value of Ford, GM and FCA. It was as if in exchange for your dollar bill, the store clerk handed you a million quarters in change. Yogi Berra was once asked if he wanted his pizza sliced into eight pieces or six. He said “six, as I am not very hungry”. These shareholders are very hungry. As further testimony to the boundless enthusiasm that pervades the market, Hertz Global Holding, the bankrupt rental car company proposed a share offering to the bankruptcy court which initially approved the idea. Hertz has $19 Billion in debt and virtually no revenue. The offering was full of disclosures that stock was likely to be worthless, yet they raised $29 MM before the SEC stepped in and stopped the process to protect CBD-using investors from themselves.

Private equity has developed its own arsenal of acronym labeled weapons to disintermediate the structures of the Fund agreement. SPAC, SPV, Single Asset Process and Fund Recap are but a few of the recent methods developed to provide the fund manager with a continuing economic option on an asset that will no longer be subject to the collective accounting of the underlying fund that transfers the asset to the acronym entity. The potential growth in the value of the asset is no longer available as protection to the fund’s investors against the decline in the value of its remaining assets, yet the fund’s manager continues to participate in any investment gains. For the fund investor, there is the benefit of more short-term cash in their pockets while the preferred return on the transferred asset terminates. As Covid’s effects on portfolio companies’ EBITDA and exit prospects became apparent this spring, many funds also paid off their credit lines as they were fearful of an impending liquidity crisis among their investors from whom they needed to draw capital to pay down the lines. Credit lines let funds arbitrage against their preferred return requirements, as the cost of the loan is much cheaper than the typical 8% preferred return rate. Now funds are seeing the confluence of reduced earnings caused by Covid, deferred exit timing caused by Covid and a higher burden due to retirement of credit lines. With the passage of time, net IRR’s will decline simply as a matter of math and approach or sink beneath the preferred return level. This has led to the proliferation of the “continuation vehicles” as a way to halt the Fund math while retaining economic options for the fund manager.

I’m Rob Morris and I approved this blog.

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