Equities in a given sector, whether public or private, tend to be highly correlated, but external observers just don't really get the full picture unless they dig into the specifics of the situation.
IME, private marks in aggregate are less volatile than equivalent public performance for a wide range of reasons, but that doesn't mean that a private manager can liquidate a portfolio company at an optimistic mark in a downcycle any more than the manager wouldn't be able to get a better price than the last mark in an upswing.
I think it's also worth clarifying for other readers that the risk you're talking about is volatility and has nothing to do with the actual fundamental risks of a given investment. Private equity (broadly defined) managers look to minimize risks in their investments, but they're talking about business and financing risks. I don't think I've ever heard a private equity manager ever talk about minimizing volatility and I'm ok with that.
I disagree on the choice of benchmarks as they're not really comparable. A more comparable benchmark for angel investments in Internet / SW startups would be a broad-based ETF that covers those. Picking a couple of the larger ones, I looked at the same periods (2012-2019 and 2016-2019) for each of them:
Not much different than QQQ's 3.04x, but SPY is not a good benchmark due to big differences in underlying constituents.
I'd want to get a better handle on the timing of investments as well to make the benchmark more comparable - e.g., if 50% of the capital was deployed in 2012 (hypothetically) and 10% in each of the following 5 years then I'd weight my benchmark performance in the same fashion.
Finally, I would want to discount the angel investment portfolio for lack of control and liquidity. Much depends on the specifics of the recent fundraising - is the valuation using the pref figure or is it a reasonable approximation of the valuation of the seed paper (adjusting for structural differences)?
Personally, I'd rather have a well-diversified liquid ETF return of X than a portfolio of illiquid minority stakes that are marked to 1.2X. At 2X, I'd be happy with the restrictions.
Please don't misinterpret this as dumping on the result - IMO I believe this to be an above-average outcome and I congratulate the author on their success. Angel is harder than most if the top-few % of investments are not in a portfolio.
Good explanation. I'll nudge it even more with a Scenario C to further illustrate that ignoring non-cash comp leads to an distorted picture.
Scenario C: Company hires an engineer with zero base salary and $200k/year worth of stock that gets paid monthly with the correct number of shares to get $16.7k in value. The shares can immediately be sold back to the company for the full value.
The engineer clearly receives $200k of economic value. Whether the stock is sold or not has no effect on the value transfer.
Does this hypothetical company have 1) a 100% profit margin, or 2) is it losing money?
If you picked 1), let's say the engineer quits and for whatever reason the company needs to pay the replacement $200k/year in cash. To do so, the company sells $16.7k of shares to an investor each month. Is it still a 100% margin company?
1. It's important to distinguish between liquidity risk and solvency risk. Liquidity risk is needing to sell an asset that is fundamentally sound and not being able to get a fair price, or any price at all (as happened in 2008/2009 - no/few buyers and many sellers). Solvency risk is the asset goes bad and there's a permanent impairment.
Simplistically:
liquidity risk = broken leg (painful and needs immediate treatment, but recovery over time likely)
solvency risk = horrible cancer
2. CLOs are made up of bank loans, which are generally the most senior obligation of a company, and are the least risky. Bonds, preferred equity and common equity get hit before the loans are impaired. During the period from 1998 through 2016, defaulting loans recovered 66% of their value while bonds recovered 40%. [0]
3. CLOs generally made it through 2008/2009 without any major issues. The structures held up as designed, but prices fell along with other structured products since there were few buyers and many sellers.
If you were able to hold, you did reasonably well. Over the 20 year period from 1994 through 2013, there were 6141 CLO tranches, of which 0.41% defaulted (no AAA or AA defaults) and had a 0.04% loss rate. [1]
4. What has changed since 2008 is that loans are becoming a larger portion of the total value of the business (loan-to-value). This means that if the business goes bad, there's less of a cushion for the loan and recovery rates will be lower.
I don't know how much lower, but some of the junior tranches in a CLO could be impaired in a severe downturn. It's hard to really know, but I _think_ things would need to be worse than 2008 (or the same level of crisis, for a longer period) for AAA tranches in general to be permanently impaired.
5. Accounting plays a role here. If you are required to mark-to-market, then the market clearing price is what the asset is worth, regardless of fundamentals. If there's a panic, you may be a forced seller if you don't have sufficient reserves to get through the disruption and your mark-to-market loss becomes a permanent loss. This applies to any asset class, not just structured products.
6. I don't understand why the article brings up CDS gaming. It's a real issue, and one that is being worked on, but it's not even a rounding error compared to the size of the corporate debt universe. [2]
quote from the FT article:
"Isda’s method of “fixing” CDS has always been akin to “patching” software after hackers exposed weak points. When one window closes, traders simply find a new one."
[0] "JPMorgan Default Monitor 4Q16"
[1] “Twenty Years Strong: A Look Back At U.S. CLO Ratings Performance From 1994 Through 2013”
IME, private marks in aggregate are less volatile than equivalent public performance for a wide range of reasons, but that doesn't mean that a private manager can liquidate a portfolio company at an optimistic mark in a downcycle any more than the manager wouldn't be able to get a better price than the last mark in an upswing.
I think it's also worth clarifying for other readers that the risk you're talking about is volatility and has nothing to do with the actual fundamental risks of a given investment. Private equity (broadly defined) managers look to minimize risks in their investments, but they're talking about business and financing risks. I don't think I've ever heard a private equity manager ever talk about minimizing volatility and I'm ok with that.