Vltava Fund: Literal Mania To grab Up Farmland In The Czech Republic

Vltava Fund letter to shareholders for the second quarter ended July 2015 titled, “A Lack Of XXX.”

Dear shareholders

In the second quarter of 2015 the Vltava Fund’s NAV decreased by 2.4%.

Vltava Fund – The alternative scene

In my previous letter to shareholders, I wrote about the bubble in bond prices. Although their prices have since turned downward – and at times quite significantly – they remain ridiculously high. Today I want to focus in on some other asset types. These are sometimes referred to collectively as “alternative” investments, and this might create an impression that they are something above standard. According to those who promote them, alternative assets also require alternative approaches to their valuation. In fact, however, it applies to all investments – whatever label we put on them – that their value equals the present value of their future cash flows and that the relationship between price and value is decisive.

Markets in general have a cyclical nature, and when the cycle is in its upper phase there begin to appear signs of maturity that include certain side effects. Generally, prices are higher, investment opportunities fewer, and the access to cash cheaper and easier. On the investors’ side, meanwhile, we see underestimation of risks and frequently the investors’ mistaking the results of a bull market several years in the running as evidence of their personal ingeniousness. On the side of companies offering financial products, there is a never-ending cleverness and capability to exploit this situation and to sell everything they can. Unsuspecting investors then venture into things they do not understand in the least but nevertheless feel good inasmuch as they took an alternative route.

Vltava Fund – Private equity

It seems almost everybody and his brother is founding a private equity fund these days. The word private sounds nice. Everything private is good, is it not? This word has a different meaning in this context, however. It is used in contrast to the word public and means that these are investments into shares (equity) of companies that are not publicly traded. So, what are their advantages? These shares have low liquidity and their pricing is not transparent. The basic idea of private equity is to buy controlling shares in companies, then manage them for some time, and finally, utilising large quantities of debt, either bring them to the public market or sell them on to a third party. Private equity sounds alternative and appealing. A more accurate name for this, however, would be “leveraged investments into untransparently priced and illiquid shares”.

But what is so important about liquidity and transparency? We could sell 90% of the Vltava Fund portfolio at any time within a single day while not influencing the prices of the shares we hold. Even though we are long-term investors and our investment horizon is 5 years and more for the individual investments, high liquidity has its option value. A situation can arise wherein this will be invaluable. The liquidity of private equity investments is exceedingly low, and in certain more critical periods it is practically zero. Little wonder, then, that private equity funds are constructed as closed, which means that investors cannot leave the fund for a number of years. As things go in life, the inaccessibility of one’s money in private equity investments usually appears to be a handicap only at such time as one most needs it.

If we at Vltava Fund hold, for example, Wal-Mart Stores, Inc. (NYSE:WMT) shares, then there cannot be the slightest doubt as to what is their price. One needs only to look at the market. We can have our own idea as to what is their intrinsic value and what their price should be, but a market price is always used for valuation. We have no influence on it, and it is therefore entirely transparent. This valuation method is called “marking to market”. Private equity funds cannot use it, because their companies’ shares are not traded anywhere. They are using the “mark to model” method, and that means that they value the companies in their portfolios according to some model. Even though they always avow that this is an independent, expert, and fair approach, this assertion is wholly open to dispute. First, the models used are either the private equity firms’ own internal ones or those of companies they hire and pay. There is no independence. Second, there is no objectively defined company value. This will always be a subjective and imprecise estimate. Here, creativity knows no bounds. For example, a multiple of the company’s EBITDA is very frequently used in the value calculation. Every professional investor knows very well that EBITDA is a wholly nonsensical indicator in this respect, and that it is used either by those who do not know what they are doing or by those who know precisely what they want to achieve by using it. “Mark to model” then frequently transforms to “mark to fantasy”.

Low liquidity and low transparency cannot be denied. What arguments do sellers of private equity use to balance these out? Essentially they use three arguments.

First, they maintain that they can find excellent companies and then manage them excellently. Everyone says that, but this is not quite so easy in practice. Offering a financial product and managing a company are two entirely different things requiring wholly different skills. In my career, I have done both and I think I can judge that a little. I do not want to wrong anyone, however, and I concede that some people have both sets of skills. The question is, however, whether investors into private equity firms can know that in advance. When I imagine how many excellent companies with demonstrably excellent managers are traded on public markets, it seems to me almost futile to venture half-blind into private equity.

Second, private equity investments are allegedly less volatile and therefore less risky. Of course, if the sellers of private equity funds value their investments using their own models, then their valuations will certainly be less volatile than, for instance, those given by the equity market. But then we are comparing apples to oranges and reality to dreams. When during 2008–2009 equity markets fell by a half, what happened to prices of investments held by private equity firms? They fell by at least as much, and in many cases they became entirely unsellable. The fact that this had no effect on the valuation models of private equity firms is no proof of a less volatile business; rather, it proves that valuation methods had diverged from the market reality. In addition, I believe that its working with substantial debt makes private equity much more volatile and risky than it is presented to be.

Third, private equity allegedly brings higher returns. That may be true for the managers of those funds but not for their investors. The fee structure, long-term closed character of private equity funds, and assets valuation using their own models create a great asymmetry of returns. When the fund fares well, its managers collect a large proportion of the returns; when the fund fares badly, the investors bear the losses.

The business model of a private equity fund is usually based on several crucial steps: Promise unrealistically high returns, collect the investors’ money and lock it in for as long as possible, and set up the fee structure so that the managers have guaranteed high returns almost without regard for how successful they are. That is the sad reality. For the first several years, when the assets are valued in accordance with internal models, good returns – at least on paper – can be counted upon. And when push comes to shove and it perhaps appears that returns are much lower than promised, there is always some trick up the sleeve to cover it. Such as by diluting the failure with new money from unsuspecting investors. The show must go on!

Vltava Fund – Farmland

In recent years, there has been a literal mania to grab up farmland in the Czech Republic. The main arguments are as follow: the price of land is always rising, its price is low in comparison to Austria, and the amount of land does not increase. Such arguments can scarcely be resisted. It is not true, however, that the price of land is continually increasing. All one has to do is to look at other countries and into history to find very soon that not only do the prices of land not always rise, but, from time to time, they also decline – and even significantly so over the long term. Yes, land is cheaper in the Czech Republic than, for example, in Austria, but it is not exceptional in history for apparently comparable assets to be valued differently even for decades. While it is true that the amount of land does not increase, the crop yields derived from it do, and at the same time the number of people in Europe is decreasing. So perhaps even the point about its amount not increasing is not so clear-cut. In any case,