Weekly Edition #69

In this edition:


One of the largest drawbacks of private equity is the lack of liquidity. Private equity funds are generally 10-year funds, in which they have an investment period (around 3-5 years), and then the rest of the time is to manage the companies and eventually sell them. From the time you invest until the fund finishes there aren’t many good options to sell out of your investment. Recently some markets have developed to trade private equity investments in secondary markets. Basically, if you need liquidity, you can sell your stake in a private equity fund to someone else. The problem with this is that since you are forced to sell, the buyer will probably pay a very low price for your stake. So, you do have liquidity but at a terrible price. 


Liquidity is an interesting subject; it is present when you least need it and vanishes when you most need it. For example, you might need liquidity during a crisis when most assets are falling. However, this is precisely when people least want to buy; therefore, your liquidity vanishes when you most need it. Also, we refer to liquidity as being able to sell something quickly at a price close to what it’s worth. Everything is liquid at the right price. For example, if you want to sell your house and are having trouble, what you need to do is lower the price. As an extreme example if you offer to sell us your house for $1,000, we’ll buy it. Doesn’t matter where it is, what it looks like, size, etc. Everything can be sold at the right price. 

We wrote about Melvin Capital a couple of weeks ago. As a quick recap, Melvin Capital was caught wrong footed with the whole GameStop and meme stock saga. They lost around 50% in January – February 2021 and failed to make up the losses in the rest of the year. They started off 2022 posting double digit losses. Gabe Plotkin, Melvin’s manager, wanted to change their fee structure to be able to charge performance fees even though the fund was still below the high-water mark. His clients were unhappy about this and eventually Gabe decided to shut down his fund. This seems unfair. Clients believed in him, which is why he was able to raise billions of dollars; however, now when they need him most he decided to cut and run. Essentially when clients most needed him to perform, right after a huge loss, he decided to shut down and only run his own money. 


This is in complete contrast to Crispey Odin, which we wrote about last week, which stuck to his fund and eventually made up all the losses. Investing is hard. Nobody knows what is going to happen. And the nature of the business is that the managers that provide the most upside generally have the highest downside. In order to earn outsized returns many managers have concentrated positions. This works well when things are going up but hurts just as much when things are going down. It’s only fair that if a manager was responsible for losing clients a lot of money, they be available to try and make it up if clients want them to. 

2021 was the year of excesses in markets. We started off with GME, AMC, and all the other meme stocks which went “to the moon”, and eventually came back to earth. This was eventually followed by a crypto boom and eventually by SPACs. A SPAC stands for special purpose acquisition company. A SPAC is essentially a company that raises money to go public and find a private company to merge with. It’s an alternative to a traditional initial public offering for a public company. There are several differences between the two but the largest is the use of forward-looking statements. Basically, in an IPO, companies cannot use future projections to market the offering. In a SPAC they can. Therefore, early-stage speculative companies like to go public via SPACs because they can make projections that make them look good, especially if they don’t have a long operating history. 

There was a lot of excesses in SPACs. Many companies went public via SPAC at absurd valuations. There was a boom in electric car companies going public and many of them proved to be frauds (Nikola), and others ridiculously overvalued (Rivian, Fisker). SPACs also have another feature that makes them very attractive for the person who raises the money and launches the SPAC. SPAC sponsors earn around 20% of the shares that they purchase in the target company. Therefore, if someone raises a SPAC and successfully merges with a private company, they stand to make tons of money. Since companies and SPAC sponsors had a large incentive to create more and more SPACs, there was a huge boom in SPAC issuance. An ETF tracking SPACs after they merge is down 72% since May of last year. As with any speculative mania, price often tend to mean revert and what has “gone to the moon” will eventually fall back down to earth. 

We wrote above that one drawback of private equity was the illiquidity of positions. Historically, common knowledge was that investors had to be compensated for taking illiquidity risk. Basically, if you agreed to lock up your money for a long amount of time, the investment should offer higher expected returns to compensate for that illiquidity. Now there’s an argument that it is actually the other way around. Since investors are often their own worst enemy when it comes to investing, then maybe illiquidity is a good thing. If investors are bad at timing when to get in and out of investments and tend to sell near market bottoms, then being contractually prohibited from selling might be a good thing for investors. 


We prefer to keep things liquid when possible. We prefer to have the flexibility to buy and sell when we choose and not be forced to do one thing or the other. The important thing is to have a plan and not act on whims. This goes a long way towards eliminating the behavioral issues with investing and acting irrationally. 

Since we first started K Squared Capital, we’ve been firm believers that investment managers, advisors, etc. need to invest in what they recommend. In the US a large percentage of mutual fund managers to not have any money invested in the funds they manage. We think this is a complete misalignment of incentives since there is no skin in the game for the manager. If the fund does well then, the manager will earn their fee and be happy. 
However, if the fund does poorly, the manager will still earn their fee and be happy. If they have no investment in the fund then there is no penalty for doing poorly, the manager does not suffer the consequences of bad performance. The worst that can happen is that they get fired and eventually move on to another job. We always say that we only invest in what we recommend, and we only recommend in what we invest. We think every investment manager should do the same. 

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