Shorting the institutional imperative

The last couple of months have seen a number of spectacular share price collapses on the ASX involving recently listed companies.

Prior to this, almost all of these companies (and their private equity sponsors) were credited with tremendous “value creation” stories over typically an extremely short amount of time before the IPO.

Institutional fund managers lapped these IPO stories up big time. IPOs were typically oversubscribed and most were market darlings for a period of time before their spectacular share price collapses.

The reality was that most of these value creation stories simply do not stand up to scrutiny when one went beyond the glossy prospectuses and delved deeper into how this “value creation” had come about.

For example, did Spotless really did add $1.2bn of economic value over 21 months of private equity ownership (being an oligopoly player in one of the the most mature and boring industries in Australia)? I am confident that there is more to come in the Spotless story.

Then we look at Vocations along with its myriad of recently listed vocational education industry peers. To anybody that actually did a little bit of homework beyond reading the prospectus, they would have been able to work out what was actually happening on the ground:

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Except investors chose to believe in the glossy marketing roadshow story of “growth in the highly attractive VET sector driven by government reform“. No one, and especially not institutional fund managers, questioned the business model.

How about turning $10m into $510m through a boring old electronics retailer? The folks at Forager did an excellent job in their widely publicised forensic piece on why Dick Smith is the Greatest Private Equity Heist of All Time.

The blame though should not be placed on the private equity funds and the entrepreneurs behind these IPOs. Their objective was simply to maximise their returns and they achieved this. They were simply doing their jobs and they did it very well.

Instead, the failings should be placed on the industry that is being paid handsomely to deploy millions of dollars on behalf of their investors under the premise that they will do the work and make smart investment decisions.

Effectively, when an institutional fund manager is running a portfolio that by mandate needs to be diversified over a large number of stocks and by mandate needs to outperform the index, they can’t risk underexposure to a hot new sector or IPO. So they are effectively forced to press the trigger on hot IPOs (which may be in effect their 30th best ideas). As an example, the bulk of the NZ fund management underperformed the index over 2013 simply because they did not invest in Xero (which had risen by 300%).

In addition, once a company gains momentum as a stellar performer and generates an eco system throwing off fat fees for the sellside community and strong returns for the buyside community, it can be very difficult not to be on this band wagon. The excerpt below from the AFR article Law firm Slater & Gordon: the long and the short sell of its annus horribilis (possible paywall) is case in point:

The BAML April 14 report was unusually blunt in an analyst community that has few reasons to question company management. Rival brokers dismissed Nadya Nilova’s work as that of an inexperienced analyst possibly out to sabotage a capital raising.

The reaction among the big buy-side clients was ferocious, and expensive for BAML. The biggest buy-side funds write the biggest orders and sources said they were openly hostile towards BAML, threatening to boycott the bank over its research.

Nilova resigned from BAML in July to join market trading firm Optiver.

I would not bet against a seasoned professional investor’s best investment idea, but their 30th best investment idea? That’s a different story and plenty of money can be made this way – in other words, by shorting the institutional imperative.

Note: The above blog post constitutes the author’s personal views only and is not to be construed as investment advice. Being obviously passionate about the art of investing, the author may from time to time hold positions in the aforementioned stocks consistent with the views and opinions expressed in this blog post.