These PE Firms Are About To Get Crushed By Their Subprime Auto Bets

In the aftermath of the "great recession," private equity firms placed massive bets on subprime auto finance companies with the typical "thesis" going something like this: "well, people have to get to work don"t they?"...genius, if we understand it correctly.

Of course, the "thesis" seemed to be confirmed when auto securitizations performed relatively well throughout the financial crisis, amid a sea of mortgage bonds getting wiped out, and private equity titans were off to the races with wall street titans from Perella Weinberg to Blackstone and KKR scooping stakes in small niche lenders.

Unfortunately, as Bloomberg points out today, the $3 billion bet on subprime auto lenders hasn"t played out precisely to plan as the "well, people have to get to work" thesis has proved to be somewhat less than full proof.

A Perella Weinberg Partners fund has been sitting on an IPO of Flagship Credit Acceptance for two years as bad loan write-offs push it into the red. Blackstone Group LP has struggled to make Exeter Finance profitable, despite sinking almost a half-billion dollars into the lender since 2011 and shaking up the C-suite multiple times. And Wall Street bankers in private say others would love to cash out too, but there’s currently no market for such exits.

 

Since the turn of the decade, buyout firms, hedge funds and other private investors have staked at least $3 billion on non-bank auto lenders, according to Colonnade. Among PE firms, everyone from Blackstone and KKR & Co. to Lee Equity Partners, Altamont Capital and CIVC Partners waded in.

 

Many targeted smaller finance companies that often catered to the least creditworthy borrowers with nowhere else to turn. Overall, subprime car loans -- those extended to people with credit scores of 620 or lower -- have increased 72 percent since 2011. Last year, about 20 percent of all new car loans went to subprime borrowers.

 

“The PE guys sailed into this thing with stars in their eyes. Some of the businesses have done fine and some haven’t,” said Chris Gillock, managing director at Colonnade Advisors, a boutique investment bank. But right now, “it’s about as out-of-favor a sector as I can think of.”

Of course, the turnaround strategy was "simple." Given that subrpime auto collateral held up well during the great recession, private equity investors figured they were sitting on rock solid collateral that would holdup under even the most egregious loosening of underwriting standards.  Therefore, given that there was "no downside", lenders wholeheartedly embraced deteriorating underwriting standards, like stretching out terms so borrowers could "afford" cars they couldn"t really afford, as a way to grow their loans books. 

Alas, it didn"t work out as planned as subprime delinquencies are suddenly soaring and used car prices are tanking...making profits somewhat elusive.

Take Exeter. The company, which is licensed in all 50 states and works with roughly 10,000 dealerships, hasn’t been profitable since 2011, when Blackstone took a majority stake, an S&P Global Ratings report in September showed. That’s after the PE firm invested $472 million to help Exeter expand and cycled through three CEOs at the lender.

 

On a pretax basis, Exeter turned a profit in 2016 and 2017, according to Matthew Anderson, a spokesman at Blackstone. He added the New York-based firm hasn’t tried to sell the lender.

 

Blackstone may look to unload Exeter later next year, said a person familiar with the matter, who asked not to be identified because it’s private.

 

Bad loans remain an issue. This year, a rash of delinquencies in two bonds stuffed with loans that Exeter made in 2015 caused the securities to dip into their extra collateral to keep investors whole.

 

Another example is Flagship, which Perella Weinberg bought in 2010. (Innovatus Capital Partners, which manages the lender on behalf of Perella Weinberg, was formed by former Perella Weinberg managers last year after they split from the firm.)

As it turns out, the "well, people have to get to work" thesis only works to the extent that auto manufacturers maintain some level of discipline and refrain from exploiting their captive finance companies to flood the market with new supply...a move which will eventually lead to crashing used car prices and massive subprime securitization losses.

Unfortunately, as we pointed out last month, a review of the latest Fed data on auto loans underwritten by "Banks and Credit Unions" compared to those loans provided by "Auto Finance" companies prove that the nightmare scenario is playing out for subprime lenders...

First, taking a look at auto loans provided by traditional banks and credit unions, one can see some marginal deterioration in subprime auto loans.  That said, the deterioration is certainly nothing substantial with 90-day delinquencies pretty much in line with 2004/2005 levels and no where near the rates experienced in 2008/2009.

 

 

But, a drastically different picture emerges when looking at just the auto loans originated by America"s auto finance captives.  To our great "shock", auto OEMs in the U.S. seem to have been much more "flexible" on underwriting standards over the past couple of years resulting in delinquency rates that nearly rival those last experienced at the height of the great recession.

 

Of course, we"re sure that GM Financial and Ford Motor Credit just got unlucky with their deteriorating credit portfolios...certainly they would never knowingly attempt to game their own short-term financial success by putting millions of Americans into cars they can"t possibly afford, right?

KKR Predicts U.S. Recession By 2019 And An Inevitable Cycle Of Millennial Deleveraging

KKR has just published their 2017 mid-year economic outlook and it includes some rather dire predictions for the U.S. economy.  Among other things, KKR predicts a U.S. recession by 2019 and a massive cycle of millennial deleveraging after a huge expansion of consumer credit in the form of student and auto loans.

Before getting into the details, here"s a chart depicting how KKR sums up the macro picture.  In short, pretty much every major economic growth and asset valuation metric in the U.S. is flashing red warning signs relative to historical norms.

Today, almost all our work streams suggest that asset prices across most parts of the global capital markets are somewhere between fair value and expensive. From a cycle perspective, we believe that we are mid-to-later cycle in some of the more developed markets, including the United States.

So, exactly where are we in the economic cycle?  Oh, just about 96 months into the typical 37 month expansion phase...which, for those who like to keep score, is the 3rd longest expansionary period in U.S. history.  Meanwhile, in terms equity returns, the S&P"s cumulative returns over the past 8 years have only been exceeded by returns that previously preceded the great depression, the 1987 crash and the tech crash...but it"s probably nothing.

Since we arrived at KKR in 2011, we have been arguing for a longer cycle. Several factors have influenced our thinking over the years. First, given how bad the environment was for jobs and growth in 2008/2009, it would only make sense that it would take longer than normal to create a sustainable economic recovery. Second, as the world transitions away from manufacturing towards more of a services-based economy, our research leads us to believe that the cycles have – on average – gotten more extended. Third, the level of monetary stimulus this cycle has been unprecedented, and as such, it will likely take much more time for central banks to unwind what is now a $14.5 trillion global QE experiment.

Though it may not feel this way to some, we are actually now 96 months into an economic expansion in the United States (Exhibit 40). Our base view is that the expansion continues through 2018, and then we run into a soft patch of economic growth thereafter. While economic expansions do not die of old age, they are affected by issues like peaking margins, heightened leverage, and deteriorating credit. For our nickel, we see all three as potential concerns being issues by 2019.

All of which, we would guess, has something to do with the following chart depicting the massive $1.8 trillion rotation out of actively managed accounts into passively managed ETFs and other index-tracking vehicles.  It"s not that difficult to see why individual company valuation metrics have become so meaningless in the age of ETF investing as investors have been lured into the false hope that the natural "diversification" of these products provides some level of downside support.  Meanwhile, the only "valuation" metric that is tracked by these "investors" is returns, so as long as money keeps flowing in, then valuations keep going up...and just like that you have a perfect feedback loop to fuel an epic bubble.

That said, we suspect it"s only a matter of time before these same investors realize that buying a basket of stocks doesn"t really provide any of the benefits of "diversification" if all the names in the basket are perfectly correlated. 

At some point, as we like to say, math and facts win over simplistic BTFD narratives.

Of course, while equity markets are screaming "everything is awesome", KKR notes that some troubling signs are starting to emerge in the actual underlying economic data.  Take for example auto sales and multifamily housing starts...

And then, of course, there is one of our favorite topics: consumer credit.

As KKR notes, as have we on numerous occasions, this latest expansionary period has been fueled in large part by a massive, bubbly expansion in consumer credit, particularly for autos and student loans.  Moreover, the biggest beneficiary of that massive expansion has been the generation that is perhaps one of the least financially secure in history....which probably helps explain why auto delinquencies are suddenly rising despite improving employment levels.

While aggregate statistics by the government for the U.S. consumer are reporting record low unemployment amidst surging household net worth, we have come to an increasingly more conservative outlook for the U.S. consumer, particularly at the low end of the market. Key to our thinking is that, as we show in Exhibit 76, basic household expenses continue to increase faster than overall wages, which is a growing issue for the large segment of the U.S. market that has not built net worth in recent years. Moreover, debt loads in areas such as student lending and autos has crept up to what we view as concerning levels. Sub-prime credit cards too should be an area of investor focus, in our view. How else can one explain rising auto defaults that now approximate 2007 levels with unemployment below the natural rate of employment?

All of which culminates with KRR"s prediction that a recession in the U.S. is imminent.

But, at least the recession isn"t coming for another 1.5 years...takeaway: Buy Moar Stocks Now.

The full report can be reviewed here:

An Absurd Unintended Consequence Of Abnormally Low Rates

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week’s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all its glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the “World Out Of Whack” as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar – because, after all, we are capitalists.

In this week’s edition of the WOW: An Absurd Unintended Consequence Of Abnormally Low Interest Rates

Even the dullest amongst us have heard about compound interest.

The story goes like this: you can become wealthy - not rich, but wealthy - by foregoing those lattes, $100 haircuts, and saving a decent portion of your income. You earn interest on those savings and let it compound.

By the time your hips are giving in and your bladder has begun to leak it"s all turned into a decent little stash while the Jones" next door who"ve spent their lives upgrading the Lexus every year and holidaying in Hawaii will be asking you for a loan to pay for the leaking roof.

This all works when you can actually earn interest on your money.

And so ever since our central bank overlords with their well intentioned but entirely destructive policies have driven rates through the floor the ability to achieve yield has been destroyed.

The distortions globally are truly breathtaking.

Take a look at this:

In the world of illiquid private assets such as venture capital and private equity asset prices are determined largely by:

1. The valuation based on the last successful financing round


2. Any liquidity event (trade sales, IPOs)


3. Or... "belly-upedness"

Last month the WSJ ran an article about Investindustrial, a European private equity fund run by one Andrea Bonomi who, while running an existing fund, just raised gobs of new money ($800m to be exact) and launched a new fund to buy the assets of the old fund.

Wait! What??

The story, according to the WSJ, goes like this:

"Buyout firms face increasing competition from patient investors like sovereign-wealth funds. One has found a way to play them at their own game: Investindustrial, a European buyout firm, is creating a new fund to buy €750 million ($800 million) of assets it already owns.

Investindustrial, founded by Italian dealmaker Andrea Bonomi, has decided on this novel course of action as it responds to greater competition for assets from institutions such as sovereign-wealth funds, which don’t have restrictions on how long they can own companies. The competition is pressuring buyout firms to devise new ways to own companies."

Maybe...

Let"s put ourselves in the shoes of Bonomi and ask a few of questions.

How would you solve a "valuation issue" as well as a "liquidity issue" when, after looking for buyers for your funds" assets, the intersection of willing buyer and that of your private equity fund"s NAV doesn"t intersect where it "should"?

If you could turn fictional paper profits into real ones with a liquidity event, would you?

If you could earn fees on both the buy and sell side of a transaction, any transaction, would you?

If you couldn"t find a buyer at the valuations you"ve been reporting to your LPs, pray tell, how would you solve both the "valuation" and "liquidity" problem?

Looks to me like Andrea is taking the mickey, but hey, if he can find fools investors willing to go along with it then who am I to be a buzz kill?

Tip of an iceberg...

Now consider pension funds who, in order to maintain their funding, need to deliver a particular return. Returns, I might add, which the liquid market are quite simply not providing them.

Remember, pension funds invest the vast majority in "safe" investments and are therefore predominately invested in fixed income markets, which brings me all the way back to the chart I started this discussion with. Yikes!

As you can see by going to zero or negative interest rates, the true market price of risk isn"t just distorted, it"s largely completely unknown at this point.

Since the market can"t function through proper price discovery mechanics quite literally every asset price globally - whether it be equities, bonds, real estate, and even cash - is distorted.

Ask any money manager what method they"re using to price risk premiums at and they"re all lost. Nobody really knows and yet we have to price assets somehow.

Private equity assets, for their part, provide these guys with an ability to extend maturities and on the face of it reduce volatility. After all, how volatile is an asset which only changes hands once every 5 to 10 years and one which has done nothing but go up as investors have been pushed further and further down the risk curve?

As Bloomberg recently pointed out:

"According to The Pew Charitable Trusts, allocations to alts by pension funds have gone from just 11 percent in 2006 to almost 30 percent today."

And as Credit Suisse in a research note mention:

"In 1980, there were only 24 private equity firms and deal volume only modestly exceeded $1 billion. Today, there are more than 3,000 U.S. private equity firms and assets under management for buyout funds are roughly $825 billion, up from $80 billion in 1996 and less than $1 billion in 1976.12 Two of the largest private equity firms, The Carlyle Group and KKR & Co, each have more than 720,000 employees in their portfolio companies, which means they both employ more people than any U.S. listed company except for Wal-Mart Stores, Inc."

Private equity ticks many of the required boxes for pension funds.

• Reduced volatility (until you have to sell),


• Higher returns.

And that, my friends, opens a whole new can of worms because, as the demographic pig moves through the python, redemptions will increase, meaning asset sales will need to be taking place. And this right at a time when global liquidity is contracting. But that is a fun topic for another edition of World Out Of Whack.

Question for the day

Cast your vote here and also see what others would do

- Chris

"Low and expanding risk premiums are at the root of nearly every abrupt market loss." — Raghuram Rajan, the governor of the Reserve Bank of India, who is one of the few economists who foresaw the financial crisis

--------------------------------------

Liked this article? Don"t miss our future missives and podcasts, and

get access to free subscriber-only content here.

--------------------------------------

An Absurd Unintended Consequence Of Abnormally Low Rates

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week’s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all its glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the “World Out Of Whack” as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar – because, after all, we are capitalists.

In this week’s edition of the WOW: An Absurd Unintended Consequence Of Abnormally Low Interest Rates

Even the dullest amongst us have heard about compound interest.

The story goes like this: you can become wealthy - not rich, but wealthy - by foregoing those lattes, $100 haircuts, and saving a decent portion of your income. You earn interest on those savings and let it compound.

By the time your hips are giving in and your bladder has begun to leak it"s all turned into a decent little stash while the Jones" next door who"ve spent their lives upgrading the Lexus every year and holidaying in Hawaii will be asking you for a loan to pay for the leaking roof.

This all works when you can actually earn interest on your money.

And so ever since our central bank overlords with their well intentioned but entirely destructive policies have driven rates through the floor the ability to achieve yield has been destroyed.

The distortions globally are truly breathtaking.

Take a look at this:

In the world of illiquid private assets such as venture capital and private equity asset prices are determined largely by:

1. The valuation based on the last successful financing round


2. Any liquidity event (trade sales, IPOs)


3. Or... "belly-upedness"

Last month the WSJ ran an article about Investindustrial, a European private equity fund run by one Andrea Bonomi who, while running an existing fund, just raised gobs of new money ($800m to be exact) and launched a new fund to buy the assets of the old fund.

Wait! What??

The story, according to the WSJ, goes like this:

"Buyout firms face increasing competition from patient investors like sovereign-wealth funds. One has found a way to play them at their own game: Investindustrial, a European buyout firm, is creating a new fund to buy €750 million ($800 million) of assets it already owns.

Investindustrial, founded by Italian dealmaker Andrea Bonomi, has decided on this novel course of action as it responds to greater competition for assets from institutions such as sovereign-wealth funds, which don’t have restrictions on how long they can own companies. The competition is pressuring buyout firms to devise new ways to own companies."

Maybe...

Let"s put ourselves in the shoes of Bonomi and ask a few of questions.

How would you solve a "valuation issue" as well as a "liquidity issue" when, after looking for buyers for your funds" assets, the intersection of willing buyer and that of your private equity fund"s NAV doesn"t intersect where it "should"?

If you could turn fictional paper profits into real ones with a liquidity event, would you?

If you could earn fees on both the buy and sell side of a transaction, any transaction, would you?

If you couldn"t find a buyer at the valuations you"ve been reporting to your LPs, pray tell, how would you solve both the "valuation" and "liquidity" problem?

Looks to me like Andrea is taking the mickey, but hey, if he can find fools investors willing to go along with it then who am I to be a buzz kill?

Tip of an iceberg...

Now consider pension funds who, in order to maintain their funding, need to deliver a particular return. Returns, I might add, which the liquid market are quite simply not providing them.

Remember, pension funds invest the vast majority in "safe" investments and are therefore predominately invested in fixed income markets, which brings me all the way back to the chart I started this discussion with. Yikes!

As you can see by going to zero or negative interest rates, the true market price of risk isn"t just distorted, it"s largely completely unknown at this point.

Since the market can"t function through proper price discovery mechanics quite literally every asset price globally - whether it be equities, bonds, real estate, and even cash - is distorted.

Ask any money manager what method they"re using to price risk premiums at and they"re all lost. Nobody really knows and yet we have to price assets somehow.

Private equity assets, for their part, provide these guys with an ability to extend maturities and on the face of it reduce volatility. After all, how volatile is an asset which only changes hands once every 5 to 10 years and one which has done nothing but go up as investors have been pushed further and further down the risk curve?

As Bloomberg recently pointed out:

"According to The Pew Charitable Trusts, allocations to alts by pension funds have gone from just 11 percent in 2006 to almost 30 percent today."

And as Credit Suisse in a research note mention:

"In 1980, there were only 24 private equity firms and deal volume only modestly exceeded $1 billion. Today, there are more than 3,000 U.S. private equity firms and assets under management for buyout funds are roughly $825 billion, up from $80 billion in 1996 and less than $1 billion in 1976.12 Two of the largest private equity firms, The Carlyle Group and KKR & Co, each have more than 720,000 employees in their portfolio companies, which means they both employ more people than any U.S. listed company except for Wal-Mart Stores, Inc."

Private equity ticks many of the required boxes for pension funds.

• Reduced volatility (until you have to sell),


• Higher returns.

And that, my friends, opens a whole new can of worms because, as the demographic pig moves through the python, redemptions will increase, meaning asset sales will need to be taking place. And this right at a time when global liquidity is contracting. But that is a fun topic for another edition of World Out Of Whack.

Question for the day

Cast your vote here and also see what others would do

- Chris

"Low and expanding risk premiums are at the root of nearly every abrupt market loss." — Raghuram Rajan, the governor of the Reserve Bank of India, who is one of the few economists who foresaw the financial crisis

--------------------------------------

Liked this article? Don"t miss our future missives and podcasts, and

get access to free subscriber-only content here.

--------------------------------------