Blain’s Morning Porridge March 10th 2023: This is not about Banks – This is a Valuation and Private Asset Crisis
“California tumbles into the sea, that will be the day I go back to Annandale”
This morning: Markets are in a fluster over US banks, but that’s not the real problem. There is a looming crisis about to roil markets stemming from inflated valuations in the Private Asset sector. This is going to get really messy. Hard Hats on!
I was going to write a trite little Friday note about how sustainability is real and much more fundamentally important that ESG, the dangers of illiquid PE alternative investments, and why we should not worry too much about the future as we have two critically important industrial revolutions heading towards us at speed: 1) Artificial Intelligence innovations which will create the next raft of Trillion Dollar Mega-Cap names we as yet have never heard of, and 2) a raft of sustainability driven ESG, climate change and renewable energy innovations which will ensure the Morning Porridge is still being written by my successors in a couple of millennia.
Instead…. One of my wife’s besties was round for dinner last night. The wine was flowing as my phone started to chirrup like a starving starling…. What’s going on? demanded the messages…
Things fall apart. The centre cannot hold;
Mere anarchy is loosed upon the World….
Surely some revelation is at hand….
Apologies to William Butler Yeats… but it is what it is…
This morning I call Imminent Crisis..
Yesterday was the judder moment in US markets, and when America sniffles the rest of us…. buy plenty of Night Nurse… Something wicked this way comes..
Yesterday, equities took a thumping, and treasuries soared on the back of US bank concerns. However, although they are getting the headlines, tumbling financial assets are not the real issue. Across markets, investment managers are desperately wondering what their illiquid, difficult to value, Alternative Investments are actually worth. Most deals will be solid, but if managers or particularly their investment committees panic, or they have reason to suspect deep losses, or if margin calls hit, funds will sell what they can – which means further falls in stocks, and a potential further wobble in bonds are still in prospect.
At the same time, the first clear signs of trouble are now visible in the US economy. As things start to go wrong, they tend to keep going wrong. We have just seen first bad news in the economic numbers as finally the US jobs market wobbles. Significant cracks across credit are starting to widen – starting off in financials, and it’s putting valuations of illiquid assets under pressure…
Back on Monday, after a week’s holiday on the slopes, I warned:
“Directionless markets – like this one – are overly sensitive to small signals. Something like a major debt shock, a no-see-um in a bank credit book perhaps… Or maybe it will be a major fund manager gating drawdowns on credit or other private investment funds …. fears about higher for longer inflation, economic hard landings and chronic one-way liquidity in credit markets could become a flash flood, potentially triggering crisis across markets as fear leaps between investment sectors… That’s pretty much what happens in every market crisis… fear becomes the vector for fear… and its often credit that triggers the shock.”
Most of these things have happened. We have a looming credit shock, we have a bond shock, and we have funds being gated. But it turns out I was wrong. Credit will no doubt become a crisis, but the immediate trigger has been Private Equity – another reservoir of difficult to value market contagion and uncertainty that is the vector for this unfolding collapse.
The immediate fear is US banks are going to see massive hits from losses in their bond holdings. The trigger has been crisis at Silicon Valley Bank (SVB), the largest bank funding big tech PE funds. It looks effectively bust as it scrambles to cover positions. It says…. “our clients in Tech Startups face a cash crunch.” NSS. Funds have been scrabbling to get their money out the bank – creating a traditional run.
SVB’s losses were actually triggered by selling its high grade bond portfolio at a loss. US banks have more than sufficient equity to cover their bond market losses (currently estimated around $600 bln vs $2 trillion in capital), so this should not lead to systemic banking failure… except that it creates a confidence failure – especially at smaller banks.
Sure enough, bank short-funding rates are doing what they did in 2007; heading stratospheric, indicating a liquidity crisis for banks. Banks don’t die slow. They die fast when the money runs out…. That’s why banks will remain the most visible pocket of trouble this morning.
SVB is certainly not too big to fail, or a SIFI (Systemically Important Financial Institution), but its moments like this when systemic gets systemic. The reality is SBV’s problems are largely related to the conflabulated valuations around Private Equity. The critical word is “valuation”.
The valuation crisis is going to be much more significant and deadly than a wobble in banking capital. We can trace the current valuation illusion back to the last decade and the speculative bubble in the value of anything – fuelled of course by articicially low interest rates, proving the rule: “The roots of the next financial crisis will be found in the solutions to the last..”
The second problem we inherit from the last crisis is risk is no longer managed by competent Bank risk departments. Risk has been “diversified” and “distributed” away from banking into the investment sector. The risks once managed by banks with access to full financial intelligence are now run by investment firms spending a shoestring budget on research and tickboxing their risk management functions.. that is another recipe for disaster….
Back in the Twenty-Teens and early Twenty-Twentys crazy ideas dominated financial markets… that cryptos were worth more than money, that growth stock Tech firms with zero profit outlook would be worth billions, that it made sense to give a SPAC founder loads of money to buy anything, and that Private Equity – getting in early to fund tomorrow’s commercial successes was a sure-fire way to riches.
Just yesterday morning I was joshing with my marvellous colleagues Julian Wheeler and Mike Hollings (who between them have seen many, many winters in the equity and bond markets respectively), about the dangers inherent in Private Equity. We observed the price of private equity is the ultimate insider’s price. Because there is no public price – is generally set between lawyers and investors all with vested interests in seeing a high price…
When the market is good… everyone is prepared to buy accept that price. When the market is bad – as it now is – the price becomes whatever the next greater fool can be persuaded to pay for it.
Unfortunately, this is now a crisis across not just Private Equity, but the whole Alternative Asset sector (my beat at Shard Capital). Illiquid assets depend on price discovery and agreement – there is no market voting machine to tell you what the price is.
Last week it was Blackstone defaulting a commercial mortgage backed deal (CMBS), reminding us the critical importance of due diligence when taking the liquidity risk of alternative investments when the only exit is what someone is prepared to pay in crisis… The assets underlying the portfolio – Nordic office blocks are discrete, very different and illiquid. When push comes to shove, they are difficult to sell at prices which match the rosy expectations of valuers. (The reality is events like this tell us just what Helsinki office space is really worth, rather than what we imagined it might be!)
Across the investment world this morning… questions will be being asked about private asset valuations. There will be shocks…
The trick in Alternative Assets (including private debt and equity) is to ensure the initial due diligence of the market opportunity was good, to understand the immediate price may have cracked due to the market circumstances although the cashflows remain good, and to have the resilience to hold the position till the current tremblor stops. The problem is – there are lots of deals out there that will look more than a little bit more chancy in this market. They will magnify selling pressure.
It’s all about valuations.
My day job is Alternative Assets. Don’t hesitate if you are looking for a bid on alternatives – we will do our best to find them, but remember in markets where confidence in imaginary prices dreamed up by holders and lawyers has collapsed: the bid is the bid is the bid, and you should hit it harder and faster then the imaginary red-headed stepchild…
Five Things To Read This Morning:
FT Robert Armstrong: SVB is not a canary in the banking coal mine
BBerg One Bank Folds, Another Wobbles And Wall Street Asks If It’s a Crisis
BBerg Thiel Fund, Venture Firms Advise Companies to Pull Money From SVB
WSJ Banks Lose Billions in Value After Tech Lender SVB Stumbles
Reuters Silicon Valley Bank scrambles to reassure clients after 60% stock wipe out
Out of time, and back to the day job… have a great weekend …. If you can!
Bill Blain
Strategist – Shard Capital