We all like to think that we learn from our mistakes. As we get later into the current economic cycle, we look for clues or lessons learned from the last cycle. Our goal is to learn from the past, to avoid the mistakes we made in prior market vintages. However, human beings are ultimately a pretty optimistic bunch. We like to believe that this time it is different or a “new paradigm.”
In real estate, one of the strategies employed in the run-up to the global financial crisis of 2008 and 2009 were public to privates or P2Ps. These strategies involved a few basic criteria: (1) targeting companies who were believed to be trading at below “intrinsic” value, (2) applying what was perceived to be a lower cost of capital to those companies, usually in the form of significant levels of cheap debt financing, and (3) rationalizing management to squeeze out “synergies”.
Guess what? Most of those P2Ps did not work! Dare I say almost none of them really worked – that is, if the objective was to make appropriate, risk adjusted returns from the investments undertaken.
Why? There are a number of reasons but a few to highlight:
First of all, the debt was never actually so cheap – many of the P2Ps’ leveraged buyouts were financed with high loan-to-value (at least 70 percent to 80 percent – or more) debt that was shorter term in nature or was structured on a floating basis. When the market corrected and underlying operating fundamentals softened, these loans went into default. Given the lack of market liquidity, the loans could not be rolled over or refinanced, resulting in significant distress. There were a few isolated cases of successful restructuring but only in cases where the sponsor had significant excess liquidity. Often times though, this additional new investment was not enough to address the issues and it ended up being good money after bad.
Also, “synergies” look better on paper than in reality. I remember being a 22-year-old, first-year analyst out of university working in mergers and acquisitions. The older and wiser 24 year olds would always say if the model did not work, keep adjusting the synergies assumption until the merger looked compelling! Well, guess what? It is a lot harder to do in the real world. Especially when one considers many public companies, especially REITs, try to run lean. And because real estate is a labor- and time-intensive asset class, it is often hard to manage more with fewer people. Managing assets is a lot easier than managing employees.
The public markets are not stupid. They may be volatile and trade with a lot of irrationality at times, but they still are a great predictor of private market valuations. When a company is trading at a big discount to net asset value, people need to consider that perhaps the NAV is too high. In fact, oftentimes the NAV is too high and the private and public market valuations subsequently converge. Sure, there might be the odd distressed situation, but usually this is just a path to rationalizing investments in an otherwise overheated market.
There are exceptions to every rule. But I would love to see the data for the P2Ps done over the past 10 years. My guess is that the performance has underwhelmed, in fact it might be downright abysmal, especially when measured on a risk adjusted basis. A great measure for that would be to see the unlevered returns those investments have generated.
Investors would be wise to consider all of this as we enter a new era of potential P2Ps. The current environment is for sure different than 2007 (and hopefully 2008/2009). There do appear to be truly distressed situations out there – out of favor asset classes and companies, bad capital structures, weak sponsorship, misalignment via externally managed vehicles – these targets might provide real opportunities. Not every company should be public.
But it is important for investors to be cautious. This has been a difficult path in the past. History may not repeat itself but it often rhymes.