When The Tide Goes Out...
You’ve probably heard the famous Warren Buffett saying…
“Only when the tide goes out do you see who’s been swimming naked.”
The tide has been going out for the past year as the Federal Reserve continues to raise interest rates. (Longtime readers know we’ve written about this ad nauseam).
We’ve been living in a world of zero (and negative) percent interest rates since 2009.
The world of finance doesn’t function properly when the cost of borrowing is practically free.
Legendary trader Stanley Druckenmiller said it best in a recent interview.
“When you have free money, people do stupid things. When you have free money for 11 years, people do really stupid things… I would assume there's a lot more bodies coming.”
We’ve seen the impacts hitting front page news. Like regional bank bank runs and the Bed Bath & Beyond bankruptcy.
These are examples of “normal” carnage.
But you’re also seeing more of the shady stuff around the margins.
Ponzi Schemes Get Exposed
Like a former Chicago commodities trader who was charged and arrested for fraud by running a Ponzi scheme. From Bloomberg (emphases added):
“A former Chicago commodities trader was arrested and charged with fraud for lying to clients about everything from a non-existent collection of 122 luxury cars to phony returns that exceeded 200%.
Phillip Galles, 57, was charged in a criminal complaint unsealed Thursday with a single count of wire fraud for allegedly stealing more than $2 million from victims whose money he falsely claimed he was investing in commodity futures, according to a statement by New Jersey US Attorney Philip Sellinger.
Prosecutors say Galles made almost no investments of any kind. Instead, he was running his firm as a Ponzi scheme, using the money to pay off early investors and for his own personal expenses, according to the government.
According to the regulator, he told prospective clients that his firm, Tyche Asset Management, was heavily staffed with former Goldman Sachs Group Inc. employees, and had “in the US $275 million under management, and $1.7 billion offshore.”
Galles allegedly claimed a “well-known owner of a professional sports team,” who is not identified in court papers, and a Kuwaiti sovereign-wealth fund were interested in investing with Tyche. He said annual returns were as high as 363.29%, according to the government.
According to prosecutors, Galles made many of his claims to two undercover law enforcement agents posing as potential investors.
To buttress his claims of wealth and success, Galles also made grandiose claims about his lifestyle, according to the CFTC. He allegedly told potential investors that his car collection included multiple Lamborghinis and Ferraris and that he had luxurious homes in Chicago, Miami and London decorated with paintings by Picasso and Chagall.”
Sounds like the exact playbook Bernie Madoff ran… until Madoff got in the middle of the Great Recession — when the economy turned down.
Annual returns as high as 363%? And not one of his clients was skeptical?
Ponzi schemes thrive in boom times. Investors either don’t feel like doing their due diligence, or the paper returns are so good, they turn a blind eye.
This is all a byproduct of a “free money” world. Ponzi schemes don’t work as well when money gets treated best elsewhere.
SoftBank Loses More Money; Reiterates Narrative
Private equity and venture capital firms are some of the biggest losers in a higher interest rate world.
We wrote about Tiger Global and SoftBank being the loss leaders back in our August 2022 piece The Biggest Loss in The History of Hedge Funds...
Here’s what we said (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.”
Other private equity firms couldn’t compete. They were getting outbid on every deal.
Venture firms had to replicate Tigers playbook. Writing bigger checks. Investing at the same speed. And waiving due diligence.
All signs of a private equity bubble.
But then inflation started to get out of hand… forcing the Federal Reserve to start raising interest rates.
Everyone knows what happened next.
Investors sold pretty much everything. Especially growth stocks — which are down 50-90% from their all-time highs.
How’d Tiger hold up?
They were down 50-65% across all their funds.
Here’s the Financial Times (emphasis added):
“[Tiger] ended the second quarter down 63.6 per cent after fees, according to a letter sent to investors seen by the Financial Times, while the firm’s flagship fund ended the first half of the year down 50 per cent after fees.”
Tiger has lost more than $25 billion total across its funds… and counting.
More than Masayoshi Son’s SoftBank. Who just lost $23 billion of investors capital in the second quarter.
Interest rates have continued to rise. And SoftBank has continued to lose more money. Not just SoftBank, but founder and CEO Masayoshi Son, too.
Here’s the headline from Bloomberg.
From the article (emphasis added):
“Masayoshi Son is now personally on the hook for about $5.2 billion on side deals he set up at SoftBank Group Corp. to boost his compensation, after the Vision Fund venture capital arm capped a year of record losses.
The Vision Fund unit lost ¥297.5 billion ($2 billion) in the three months ended March, ending the fiscal year with a total loss of ¥4.3 trillion — its worst since Son proudly set up the business in 2017. The world’s largest technology investor reported dismal earnings despite a global rebound in equities, as it suffered losses on unlisted startups in its portfolio…
His unrealized losses widened by about $130 million from three months before, with most of the deficit linked to the Latin America fund. The founder and chief executive officer of SoftBank was down $5.1 billion on the same side deals through the December quarter.
Son, whose stake in SoftBank grew in recent months, also owns portions of the company’s key investment vehicles. While these holdings have sparked controversy due to corporate governance concerns, the Japanese billionaire has denied any conflict of interest.
The 65-year-old billionaire holds 17.25% of a vehicle set up under SoftBank’s Vision Fund 2 for its unlisted holdings, as well as 17.25% of a unit within the company’s Latin America fund, which also invests in startups. He has a 33% stake in SB Northstar, a vehicle set up at the company to trade stocks and derivatives.
There is no immediate deadline for repayment and the value of Son’s positions could improve in the future, and for SB Northstar, Son has already deposited some cash and other assets. The founder would pay his share of any “unfunded repayment obligations” at the end of the fund’s life, which runs 12 years with a two-year extension.”
Of course no one’s concerned about the blatant conflict of interest of leveraging oneself to the gills on the company’s investments when asset prices are going up.
Now everyone is concerned?
SoftBank’s losses (from its private investments to its actual company’s reported earnings) continue to swell into the tens of billions. You can see from SoftBank’s presentation that its success is mostly a function of a free-money world.
Not to worry. Son is still a multi-billionaire. He’s been in the game long enough to know how Wall Street’s game is played: Feed them a new narrative.
The new narrative flavor of the day is artificial intelligence (AI).
Here’s Chief Financial Officer & Senior Managing Director Yoshimitsu Goto on their most recent earnings call:
“Masa might give me hard time. But excitement, I think is tremendous excitement he has. In the last six months alone – six months ago, generative AI, I don’t think many people heard about generative AI and new generative AI. But still, he had too many things to start around AI. And he was like – he was excited as much as when he launched the company. And sometimes I am worried if he has time to sleep because rapid growth and development of generative AI and AI itself. I think I can’t explain clearly how excited he is, but I have spent time with him every day, and I try not to be overwhelmed by him too much.”
SoftBank has been the private equity behemoth in the space for years. They still have $37.5 billion in cash on hand. So they’ll flood dozens of AI companies with money showing investors they’re ahead of the trend.
This Is What The World Needs… A Return To Normal
We’re not cheering for pain.
Whether it’s the thousands of people getting laid off within Silicon Valley. Or the implosion of most asset prices from bubble levels. Or investors getting defrauded by investing in Ponzi schemes.
Rather, this is a return to normal.
The tide is going out… and we’re seeing who’s been swimming naked.
Interest rates are the market’s way of telling you what the cost to borrow money is.
Never should the cost to borrow money ever be free.
Good investing,
Lance