After a decade of deranged monetary policies that ultimately amplified speculation beyond 1929 and 2000 extremes, we are so far from “normal’ that arriving anywhere near that neighborhood will be a journey. The recent market decline has simply retraced the frothiest portion of the recent bubble, bringing the most reliable market valuation measures back toward their 1929 and 2000 extremes – John Hussman, Hussman Funds
Calpers, the California public state employee pension fund, unloaded $6 billion worth of private equity holdings at discounts to where the positions were marked at the end of Q1. The discounts ranged anywhere from the high single-digits to as much as 20%. On the surface this may not seem like a big deal, as the $6 billion represents just 1.4% of Calper’s asset base. However, private equity investments are likely somewhere between 15-20% of Calper’s holdings.
The same is true for most pension funds. When the returns available on Treasury bonds and investment grade debt went below 1%, approaching zero for short duration Treasuries, public pension funds across the country ratcheted up their fund allocations to stocks, junk bonds and private equity. I know from insiders that some public funds increased the allocation of private equity to 20%.
The valuations of private equity positions are based on theoretical “mark-to-model” pricing. The new valuation of each company increases when the successive round of capital raises place a higher valuation on the equity of these companies. And the valuation models are based on where “comparable” companies trade in the stock market. The scheme worked great for generating higher mark-to-market rates of return each quarter and boosting the overall ROR on the fund during the years when the stock market bubbled up.
As long as the stock market was pushing the publicly traded “unicorns” higher (stocks like Peleton, Teledoc, etc), the private equity fund managers could apply rising revenue multiples to the valuation of the privately held equities. See the problem? The investment strategy at its core is a Ponzi scheme. This was being done by pension boards and managers in order to justify the payouts to current-pay beneficiaries despite the fact that the current payout stream of cash exceeded the cash inflow from investment gains and capital contributions from future beneficiaries.
The returns generated for pension funds on these positions each quarter and annually continued to rise with the stock market. But it was fool’s gold. Now all of the pension funds that jumped on the private equity bandwagon are faced with the prospect of having to write-down the valuations of most if not all of their private equity holdings. Many of the companies funded by the easy money during the bubble years will disappear, in which case private investments will have to be written-off completely.
This is an issue faced by States and pension beneficiaries that is not getting any air-time. But the report about Calpers caught my attention. I would bet that the positions that were sold by Calpers were cherry-picked because those positions had the highest bids from the buyers. Remember, these private equities trade over-the-counter in the private market, which is opaque and becomes extremely illiquid during a bear market. I am certain that many of Calpers positions had bids that were well below 50% of the price mark at the end of June and some had no bids.
As the bear market progresses, it will become apparent to many that big pension funds are in serious trouble. This in turn ratchet up the degree of financial and economic uncertainty, which will put further downside pressure on the stock market.
The commentary above is from the July 17th issue of the Short Seller’s Journal. Each week I provide analysis of the weekly key economic data plus provide short sell ideas and related put option suggestions. Currently I’m focused on the housing market, which is entering a bear market that will be worse than the 2007-2010 housing bear. You can find more information on this newsletter here: Short Seller’s Journal