Short sellers don’t often get the respect they deserve. Indeed, the activist types even tend to be branded villains by most who prefer to see stocks only going up. Yet, short sellers are important for price discovery and especially in catching fraudulent companies. But it is a hard profession. Whilst it does take a lot of hard work (research) and more importantly courage and conviction, the payoff tends to be limited. Whilst there are ways to structure it, a short trade typically has limited upside and unlimited downside unlike a long trade. It isn’t scalable either. The best known short only funds are a couple of hundred million in assets under management. Whilst every downcycle brings to fore its shorting heroes, few tend to have sustained success across cycles. Here’s a story of a young short seller who has just had great success shorting tech stocks before the 2022 fall. Nate Koppikar’s fund Orso returned 70% in 2022. Whilst in hindsight, it seemed like an obvious short, Koppikar’s tech short thesis was drawing a simple parallel between Y2K and Covid:
“What intrigued Koppikar were the similarities between Y2K and Covid-19. “The reason this became the dot-com thing is because Covid was Y2K. You had a massive spend,” he explains. “It was for hardware infrastructure and for software upgrades in Y2K. And this time it was for cybersecurity, work from home, remote, cloud.” But both Y2K and Covid-19 were temporary phenomena, and the bubbles eventually burst.”

But what is more interesting is his current open short on the private equity (PE) industry, especially the largest PE firm – Blackstone. Whilst a number of public market investors have lamented about how PE firms have it easy by not having to report mark to market losses  (read AQR’s Cliff Assness’ rant), Koppikar is walking the talk.

“…figuring out when — or how — to short private equity firms was not easy, given their ability to forestall pain through the long fund lockups and what AQR Capital Management’s Cliff Asness calls “volatility laundering,” the illiquidity and lack of transparency that obscures private equity’s risks.

It was Orso’s work on crossover hedge funds — the Tiger Cubs — that led Koppikar to Blackstone. Many of the same investors were in both, and the valuation problems were similar.

…As Koppikar explains, “Blackstone was out buying real estate like some crazy yahoos all of ’21.” The firm had raised “a ton of money,” he says, “and then they just closed their eyes and pretended the real estate market hadn’t fallen off a cliff, and rates were clearly going up and they were not doing anything about it.”

Although the stock prices of publicly traded REITs were falling last year, Blackstone “just wouldn’t mark down its book,” Koppikar says.

…Koppikar says he also looked at BREIT’s offering documents. Unlike investors in most private equity funds, BREIT investors can take their money out monthly. But buried in its prospectus were the terms of its gates. If a lot of investors wanted out at the same time, it was clear they could be out of luck. “We realized that this thing is basically locked up,” he says.

In January, when redemptions went above the monthly 2 percent fund-wide limit, Blackstone did manage to give BREIT investors 25 percent of what they’d requested.

Real estate issues aside, there are other signs of trouble in private equity as an industry that Koppikar has singled out. One is the growing popularity of continuation vehicles, which he argues involve “holding assets past the fund life by flipping it to a continuation vehicle with sweetheart economics for the private firm.”

And then there are the sponsor-to-sponsor flips — an “alarming volume of sales to other private equity firms, sometimes resulting in limited partners selling assets to themselves, a practice we regard as Ponzi-esque,” says Koppikar. (The demise of SPACs has made exits through the public markets almost impossible.)

At the same time, Koppikar argues that the upcoming recessionary impact will inevitably be less of a threat to the system because the private equity industry largely lends to itself. In this cycle, the risks will not fall on regulated banks. Instead, it’s the investors in private equity who will bear the brunt of any losses.

“Understanding the changes in the banking system is in our view the most important piece of forecasting where a Fed-induced hiking recession could take us,” he told investors last year.

The new environment can be traced to the financial crisis of 2008. When the banks were faced with insolvency at that time, the Federal Reserve engineered a way out to protect the banking system.

“The U.S. government was trying to facilitate the wind-down of Citibank’s bad debt, and Citibank’s bad debt was all of the private equity debt,” Koppikar explains. No one would buy the leveraged buyout loans, he says, so through the Troubled Assets Relief Program, the U.S. government lent private equity firms money to buy back their own debt, which gave birth to the private credit industry — what Koppikar calls the “shadow banking system.”

“I worked on it. I remember it,” he says.
Given private equity firms’ potential ability to massage the valuations and returns of their portfolios, their apparently strong performance has led institutional investors to continue investing in these funds, one after another, which has allowed assets to mushroom. Koppikar thinks it is strategic: “Private investment firms continue to hold assets at levels with no support whatsoever from public market comparable companies, often to justify raising subsequent fund vehicles.”

…There is some evidence that the forward momentum is beginning to slow. “Institutional LPs are cash strapped right now because they made huge commitments to these funds and they have to hold money back for it,” says Koppikar. Last year’s market downturn added to their agony.

“What happens is money stops coming in,” he says, citing as evidence the fact that Blackstone has been having trouble raising what it hoped would be a record $30 billion for a new buyout fund, while other private equity firms have slowed their fundraising as well.

Predicts Koppikar: “It will be a slow bleed.””

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