NAV Squeezing
We didn’t think we’d reach this level of bubble territory again.
We’re not talking about stocks — although they are overvalued by most metrics.
We’re talking about private equity and venture capital funds.
Longtime readers know private equity and venture capital funds are struggling.
They haven’t generated great returns these past couple of years. They haven’t been great at paying distributions to their investors either.
Therefore, these funds need to get creative to generate returns and/or distributions. Generating returns is what allows fund managers to launch new funds.
But some funds are taking this too far. Like, “how is this allowed?” far.
It’s called “NAV squeezing.”
Funds have to mark their assets at “fair value” — a.k.a net asset value (NAV).
NAV is what a company is worth at the end of the day.
Publicly traded companies trade at NAV every day. It’s just the most recent price of the stock. Because a buyer and seller agreed to trade at a certain price.
Private assets don’t trade daily. They’re illiquid. You can’t buy them every day. Sometimes their shares don’t trade for years. So their NAV is usually based on the last valuation the company raised money at.
Let’s say Company A raised money at a $10 billion valuation back in 2023. But Company A hasn’t raised money since. Technically Company A is still valued at $10 billion today… despite two years passing.
Private equity and venture funds are seeing this today. They invested money in these companies years ago. But these companies haven’t gone public nor have they been acquired. There’s no liquidity.
So they’re selling their investment stakes at discounts to NAV in order to get some liquidity.
This has led to a surge of continuation funds — which we wrote about last week.
Last year, $162 billion in secondary deals changed hands, with an average discount of 11%, according to investment bank Jefferies.
Hamilton Lane Private Assets Fund is buying shares in private companies at discounts… then immediately marking them up to NAV.
What Hamilton Lane is doing is technically legal. But it’s a slimy business practice.
It’s as egregious as what many venture firms did during the 2020-2021 bubble. The two biggest violators were Tiger Global and SoftBank.
Here’s what we said in our August 2022 piece The Biggest Loss In The History Of Hedge Funds (emphasis added):
“Tiger was the behemoth in the private market.
They had more money than everyone. They were willing to write bigger checks faster than anyone. And they did.
There were accounts of Tiger writing private equity checks within as little as 12 hours after hearing a company pitch.
In its 2020 anniversary letter, the firm said it was “searching for ways to make our investment flywheel spin faster.”
Tiger’s Founder Chase Coleman was lauded as a revolutionary. One who took private equity investing to a new level.
Tiger was replicating a page out of SoftBank’s playbook… writing even bigger checks to their earlier investments and marking up the valuations on those companies.
“One of those unspoken ‘rules’ Tiger Global broke was allowing separate Tiger Global venture-capital funds to invest in the same company. This practice had often been prohibited in VC-land in the past because the newer funds can end up making the older funds look better simply by buying a piece of the companies in the earlier funds’ portfolio. ‘In most cases, you’re not allowed to do this,’ says Michael Ewens, a finance professor at the California Institute of Technology who studies entrepreneurship, referring to provisions in contracts between VC fund managers and their investors.”
Of course, Tiger and SoftBank got obliterated when the tide went out — When the Federal Reserve started raising interest rates.
Hamilton Lane is doing something similar. From the Wall Street Journal (emphasis added):
“With $3.6 billion in net assets at the end of March, this fund is a fast-growing player in the game of buying chunks of private-equity funds in the secondary market. In the first quarter, the Hamilton Lane fund took in an average of more than $4 million a day of new money from investors.
That’s thanks largely to its remarkable performance. Counting a predecessor fund’s returns, since September 2020 the fund has gained an average of 16% annually, outperforming the S&P 500 by an annualized average of nearly 4 percentage points.
Like other such funds that invest in secondaries, Hamilton Lane Private Assets can buy private-equity stakes from other holders, often at a deep discount to the official net asset value. It can promptly mark up its holdings to that official NAV. By doing so, it disregards the discounted price it just paid—even if that price was set in a competitive auction…
But the firm could collect the money only “deal-by-deal,” when it sold a specific secondary investment at a profit. And only the portion of profit in excess of 8% was subject to the performance fee. (On other assets, the incentive fee kicked in on gains above 6%.)
Because it has sold almost none of the holdings, Hamilton Lane had collected a grand total of $1.6 million of performance fees. (It did take in $41 million of ordinary management fees last year at a 1.5% annual rate, which will drop to 1.4%.)
Under the old contract, Hamilton Lane couldn’t collect more incentive fees because the gains on the fund’s underlying assets were unrealized. In fact, if the assets turned out someday to be worth less than Hamilton Lane says they are, the manager might never have earned some of those fees.
Under the new arrangement, which was approved in March by 96% of voting shareholders, the performance fee falls to 10% from 12.5%.
From now on, the incentive fee will be payable across the entire fund, not on each deal measured independently.
Note carefully: The new fee is payable not just on realized gains, but on unrealized gains as well. That means Hamilton Lane no longer has to wait to sell each secondary holding at a gain of at least 8% to take its cut.
Even if the fund still holds the assets, any gains above zero will count. And those are easy for secondary-fund managers to generate when they can unilaterally mark up assets they bought at a discount.
Thanks to the new fee structure, Hamilton Lane took in $58 million of incentive fees from the Private Assets Fund after the shareholder vote. That was money the manager otherwise might not have received for years, if ever.”
This is absolutely shameful. It’s a black eye on the private equity industry.
But shareholders approved this. So this is what they signed up for.
Imagine the future headlines (and maybe lawsuits) when Hamilton Lane “mispriced” their investments… and then subsequently refused to let investors redeem their capital.
For now… the charade continues.
Good investing,
Lance
DISCLAIMER: This is solely our opinion based on our observations and interpretations of events. This should not be construed as personal investment advice.