#writing Exploring some of the dynamics behind negative carry investment strategies. --- **April 15, 2024** Private credit funds are boasting low-double digit returns with a senior secured credit risk profile; private equity funds have raised $12 trillion and are seeking to deliver double-digit returns on that capital; and nominal GDP is growing around 6% annually. These numbers just do not add up. When the aggregate cost of capital for the economy is higher than the growth rate of the economy, as it is in this case, things are not going as well as the promoters are telling you. The nominal GDP of the US economy was nearly $26 trillion last year. Double digit annual returns (lets assume 15%) on $12 trillion of capital represents a $1.8 trillion cost of capital or nearly 7% of nominal GDP. That means that nominal GDP needs to increase by at least 7% a year to keep up with cost of capital. The size and return requirements of private equity and private credit not only represent a headwind for the economy, they represent a challenge for the fund managers to achieve their targeted returns. Take for example a hypothetical PE-owned company with 40% margins and six turns of EBITDA worth of debt at 12%. Those six turns work out to 72 cents of interest cost for every dollar of EBITDA which works out to required revenue growth of 80% to make up for the increased interest expense. You can see how it becomes increasingly difficult for firms to grow fast enough to cover increasing debt burdens. While firms can remain profitable the profits are increasingly being diverted to the lenders. However unsustainable or irrational this may seem we know all too well from experience that unsustainable and irrational things sustain far beyond reason. [[CHG Issue 102 Fallacy of Composition|The fallacy of composition]] brings it about that rational actors can all act rationally but in combination produce and irrational outcome. Just because the outcome is irrational does not mean it is destined to end imminently. We established a [[Entropy|framework]] for understanding this a few weeks ago that we can apply to this situation. The process at work is one where private equity has been the star performer for a long time and that view has become ensconced in the public consciousness and heavily influences the cognitive function that determines extrinsic value. Absent any updates to the contrary, the view of intrinsic value is outweighed by the view of extrinsic value. ![[Pasted image 20240415093909.png]] ## Time Dimension It would be reasonable to infer that time is working against private equity since they are essentially running a negative carry strategy; however private equity can fund with private credit in the short-term and still make their returns. In fact, they might be smart for doing so because the long-term asset value they are building will far outweigh the short-term negative carry. More practically, they can borrow expensive capital to do dividend recaps and return money to their investors which reinforces the conventional wisdom and puts off any update of new information while leaving the creditors on the hook for the ultimate asset value. Once low rates return they can refinance once again and put their operations on a more sustainable footing. ## Liquidity Dimension As the IPO market has shrank private equity managers have increasingly used debt as a way to realize liquidity on their investments. In doing so they are essentially buying puts on the assets of their portfolio companies while taking out the proceeds to return capital to their investors. They can effectively "sell" their companies at a lower price (the amount of the debt) while retaining control and upside but paying the put premium in the form of high debt service costs. In effect, managers are transforming their portfolios into long call options on the assets of their portfolio companies. When viewed from this perspective the value proposition of private credit looses a little bit of its luster. ## Credit(Value) dimension As private equity continues to transform into portfolios of call options and private credit becomes portfolios of short puts on private equity portfolios of the ultimate realization of the asset value of these companies gains importance. If credit conditions ease or the liquidity for portfolio companies increases then private equity can realize its gains and private credit gets its 12% returns. From a risk-reward perspective private equity presents a more favorable proposition in this case since private credit is taking most of the risk while only earning a portion of the return. If on the other hand private credit chokes off private equity and liquidity does not return or we experience a drop in asset values then private credit could be in the position to take over attractive assets from the private equity managers. Whether they can execute on that is dependent on the private credit manager, but the ones who lend to own a business should do well in this scenario. Private equity investors will suffer losses but they have already received some return of capital from all the dividend recaps and other financings so the drawdowns will not be that bad and what we will likely see is many "opportunistic" funds raised by the same managers to buy back their portfolio companies from their private credit lenders at a discount. This is the way Wall Street works; today's problem is tomorrow's opportunity. Charles McGarraugh's theory of [[CHG Issue 143 Finding Order in Disorder|asset duration]] asserts that feedback is more powerful the less it is exposed to the realization of information. We have been experiencing this in the public markets for nearly two years now as investors have been waiting for a recession and Fed easing but have yet to get either. The power of that ultimate feedback grows as the market continues on without any realization of information. Private Equity is in a similar situation: the traditional private equity strategy of buying smaller, cheap companies, borrowing to improve them, and ultimately selling them at a profit has been priced out of the market for years, but that has not hindered the industry from continuing to grow and raise AUM. Realizations on private equity portfolio companies has been continually pushed out into the future due to a shrinking set of exit options. Low rates and easy credit conditions cushioned the industry for years but now rates are higher and credit is tighter. If the current environment is adverse enough to cause a realization event the impact of it could be very powerful. However, it would be a mistake to conclude that private equity is set up for a fall. While the industry is standing on one leg, and that leg is increasingly weakened, we know that the power of the imagination which fuels extrinsic value can carry on far beyond rational reason; and as we have demonstrated how even in adverse scenarios private equity and private credit may be able to capitalize on that distress.