Oaktree Capital Management co-chairman Howard Marks warned investors that “'they' are at it again – engaging in willing risk-taking, funding risky deals and creating risky market conditions”, in his latest memo to clients.
“Since we never know when risky behaviour will bring on a market correction, I’m going to issue a warning today rather than wait until one is upon us,” Marks wrote.
The wide-ranging note – which ran to more than 10,000 words – touched on everything from emerging market debt to digital currencies, and borrows from previous cautionary notes Marks has penned over the years.
On private equity, Marks noted that today’s low-return world is driving investors toward alternative investments, particularly real estate, distressed debt and, above all, private equity, which is attracting capital at “all-time-high rates” thanks to a strong return track record.
However, Marks cautions that investing the hundreds of billions of dry powder – augmented by leverage, which is likely to take the real number above $1 trillion – could be a challenge as asset prices remain full.
“I’m not saying private equity isn’t a solution, or even that it’s not the best solution. It’s just that its record fund-raising is yet one more sign of the willingness of investors to trust in the future.”
Marks then went on to dedicate a whole section to the $93 billion SoftBank Vision Fund:
“Perhaps the ultimate demonstration of faith in fund managers is SoftBank’s recent raising of $93 billion for its Vision Fund for technology investments – presumably on the way to $100 billion. SoftBank is a Japanese telecom company showing an 18-year annual return of 44 percent on investments that have included chipmakers, ride-hailing and telecom. But I see issues with the fund:
First, SoftBank’s record of investment success has relied heavily on one phenomenal investment. The $20 million Softbank invested in Alibaba in 2000 has grown in value to more than $50 billion. Skill or luck? And extrapolatable?
Second, size matters. In 1999-2000, the venture capital industry got into trouble because it followed massively successful mid-1990s funds of hundreds of millions, with funds of $1 billion-$2 billion. The Vision Fund isn’t for startups, but still, can you wisely invest $100 billion in technology?
Third, here’s an organization that has never managed money for third parties, starting the biggest fund in history to do just that. Is their experience transferrable? In all these regards I think the fund indicates a high level of enthusiasm and a low level of scepticism.
Fourth, and perhaps more importantly for my purposes here, I want to spend some time on the fund’s structure. For each 38 cents they put into the fund’s equity, outside investors are required to put 62 cents into preferred units of the fund. On the other hand, SoftBank itself invested $28 billion in equity but nothing in preferred.
• That means when the fund reaches $100 billion, SoftBank will have put up only 28 percent of the capital but will own 50 percent of the equity. Adding in management fees and carried interest, its 28 percent of the capital may give it 60 percent-70 percent of the gains.
• Even the private equity industry – with its willingness to take risk – has traditionally shied away from piling debt on technology companies (although less so lately). SoftBank doesn’t hesitate to lever its tech investments.
• The preferred units will pay a 7 percent annual coupon. Lending money to a tech fund at that modest rate apparently is part of the price demanded of the LPs for an opportunity to invest in the fund’s equity. I can imagine the sales pitch about how lucky the LPs are to get a chance to provide leverage for their own investment, but I doubt I’d be convinced.
• Finally, as the Financial Times wrote on 11 June:
While the preferred unit holders will eventually receive their principal back [plus 7 percent per year], they will only receive [an equity] return for the equity portion of their investment in the fund.
All outside backers of the fund are receiving 62 per cent in preferred units and the rest in equity, allowing them to reduce their downside risk, while still generating a good return.
Sounds good on the surface. But how much does this diversion of the investors’ capital into preferred units really reduce their downside risk? The FT says investors in the preferred units “will eventually receive their principal back”. Should that really be “will,” or perhaps “may” or “hopefully will”? Does a $100 million investment in the fund put only the $38 million of equity at risk, or is there risk associated with the preferred, too? I guess I don’t consider the preferred units as rock-solid as the FT suggests. Aren’t they more like the Netflix bonds: tech-linked downside with no upside? Would an arm’s-length lender give an LP money at 7 percent to lever his equity in this fund 1.6 times?
The willingness of investors to invest in a shockingly large fund for levered tech investing with a questionable structure is a further indication of an exuberant, unquestioning market.