Summary: Of the 89 CEFs left on the ASX, three are mature private equity funds investing in mid-market U.S. companies: CD1 (2012), CD2 (2013) and CD3 (2016). I've owned the CD Funds (previously Cordish Dixon Private Equity Funds) since 2019 and still have major stakes in CD2 and CD3. Using my CD Private Equity Fund Insights website, I advocate for the interests of CD Fund retail holders, which included blocking the E&P proposal to consolidate them into an evergreen mashup fund with extractive performance fees (thus eliminate self-liquidation).
More than any Closed End Funds, I've spent countless hours discovering the complexities, opaqueness, pitfalls and rare opportunities of the private equity world and CD Funds. But I can afford to share some lessons publicly, even if it costs me in future given my large holdings. There are many pitfalls and myths affecting retail investors in private equity.
For prior details on the CD Funds, see my CD Funds Insights website. While I normally focus on just one aspect of CEFs, in this post, I will maintain (add to over time) a list of the lessons I've learned investing and trading in the CD Funds. The aim is to write them up in simple language to warn existing CD Fund retail holders and prospective retail buyers.
Note: I am not an expert in private equity, but am an expert in the Closed End fund structure, so this post focuses on lessons about such funds as closed end investments. Long-term retail holders only get the scraps in private equity, so the only expertise that matters to them is whether they should ever be invested in private equity funds. All supposed "experts" with vested interests say they should; I reveal with facts why they shouldn't.
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| It's death by a thousand cuts for retail investors in the private equity dungeon! |
Details:
The aim of these "Cheat Sheets" is to reveal how difficult it is, even with genuine expertise, to outperform cheap index funds with CEFs in the long run. I reveal just one important but little known insight for each ASX CEF. It is not the only insight; nor always the most important one. I vary the insights to show how unnecessarily complex and hazardous CEF investing is. For detailed ASX CEF insights and expert services please use the Contact page.
Update: The AFR wrote up a typical puff piece on the Cordish family's private equity endeavours (including seeking more funds from wholesale and retail in Australia). See: > AFR: Why an American dynasty is tapping Aussie investors for money
1a. NTA Returns: Inception to 31 Dec 2023 (Sharesight; no reinvestment of distributions)
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| Start NTA: $1.55. End NTA: $1.02. Total Distributions: $2.77 |
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| Start NTA: $1.54. End NTA: $1.54. Total Distributions: $2.26 |
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| Start NTA: $1.52. End NTA: $1.87. Total Distributions: $1.69 |
In its 31 Jan 2024 CD Fund Series Presentation, K2 Asset Management published NTA returns from inception to 31 Dec 2023 as below. Until they can prove their calculations (inclusive of optional decisions like reinvestment), I would conclude the K2 returns are incorrect and investors should rely on Sharesight. (CAGR returns can be cross-checked accurately in Excel and I have validated Sharesight returns many times and can do this again if disputed).
1b. TSR Returns: Inception to 31 Dec 2023 (Sharesight; no reinvestment of distributions)
Total Shareholder Returns reflect the actual return to investors, especially for Closed End funds where discounts and premiums are a significant factor. As you can see, TSR returns since inception are lower than NTA returns by 1% CAGR for CD1, 1.7% for CD2 and 2.8% for CD3: | |
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| Start Price: $1.6. End Price: $1.42. Total Distributions: $1.689 |
1c. My TSR Returns: First Trade to 31 Dec 2023 (Sharesight; no reinvestment of distributions)
Regarding CD1, I've never owned it for significant periods, so it's not worth publishing here.
For CD2, my TSR returns (trading not just holding) have been somewhat higher than the NTA and example TSR returns from inception. They were brought down due to a single big trading loss during the E&P proposal to create a combined evergreen mashup fund.
For CD3, my TSR returns (trading not just holding) were not affected by a trading loss during the E&P evergreen proposal. While I massively outperformed the NTA and example TSR returns from inception, this is just illustrative of Reason 15 (Trading is a zero sum game) in my post: > CaptiveCapital's 95 theses on why ASX Closed End Funds should be eliminated.
Indeed, the biggest issue with the massive gap between the 33.4% CD3 return ($340,963) I've made and the circa 9.36% TSR of a unitholder since inception is that the CD fund prices have been volatile as have been NTAs (both reported NTA and the actual periods NTA changed given 3-6 month lags). Then there have been the ridiculous machinations of E&P such as the evergreen mashup proposal. Very few CD fund holders have never sold (even if just to slowly sell down), so net trading profits made by sharks are equally matched by net losses among mostly retail.
Hence, even the star performing CD3 fund has not delivered anything like a 13.9% CAGR (K2's figure) since inception for the average retail client. It has delivered 9.36% (the TSR) minus Net "trading" losses. I estimate CD3 Retail TSR at ~7% CAGR. Likewise, I estimate CD1 and CD2 Retail TSR at ~5% CAGR. I welcome CD Fund holders to post a screenshot on Hotcopper of their actual TSRs (% terms) from Sharesight. It would put to bed any ideas retail investors are getting returns anything like K2's figures.
2. Key Insight: Lessons from investing and trading the CD Funds
Q. Is K2 Asset Management doing a much better job than E&P as responsible entity? Will this narrow the discounts for CD1, CD2 and CD3?
Yes, in most respects, they are. Unfortunately, it will hardly affect the discounts. K2 spends a considerable amount of time and effort communicating with retail clients (who are mostly retirees) and their financial advisors. These complex PE funds were mis-sold to naive Dixon Advisory clients who are now tied up much longer than expected, with uncertain distributions, exits and timeframes. The continual overhang of these sellers drives the large discounts.
This communication load is inefficient and, as most have financial advisors, K2 should just publish simple explainers for all common queries on the vastly underutilised CD Funds website (e.g. using fiverr to get diagrams/videos created) and devolve much of the one-to-one effort to financial advisors. I doubt that will happen though, and I'm not optimistic on K2 narrowing the discounts through standard Responsible Entity duties (no matter how professionally performed). Closing the discounts is a much more difficult task in comparison.
Q: Is K2 Asset Management working effectively with Cordish Private Ventures to serve the interests of CD Fund unitholders?
Mostly, I'd accept good faith, but K2 is not an expert in private equity and is simply led by CPV as to the feasible options available. Having taken over from E&P, K2 is trying to balance the interests of all unitholders in clarifying distribution expectations, winding down the funds as they get past 10 years, but aiming not to sacrifice too much of fund value in expediting this.
Nevertheless, like all financial services firms, K2 depends on relationships for future business and the Cordish family is extremely wealthy. K2 is not going to explain to unitholders the various ways most of the returns in private equity (including the CD Funds) are captured by fund managers and insiders.
The long-run Total Shareholder Returns for all four CD Funds are what really matters (which will include NAV losses at commencement, value extraction along the way, and any discounts to wind up). I'm convinced these underwhelming long-run TSRs will be be further proof of the thesis of this CaptiveCapital site. (Of course, I will be publishing the returns on this site!)
K2 didn't set up the CD Funds, and it's important, as the Responsible Entity, that it doesn't see its role as defending them or protecting CPV.
Q. If Cordish Private Ventures is investing hundreds of millions in private equity, why can't it spend a hundred million mopping up the remnants of the CD Funds if they get beyond 12 years?
At the presentation, Jonathan Sinex mentioned that after CD4, CPV had invested $100 million a pop in CD5, CD6 and CD7 and was in Australia seeking investors for CD8 (all unlisted funds and not open to retail). I think what's more likely is CPV raised circa $100 million funds but GP's like CPV usually invest only a few percent in them while extracting the biggest returns.
An audience member asked the obvious question: Given CPV is confident of its conservative valuations, claims it prefers to wait for realisations, and continuously runs funds with this mid-market PE exposure, why doesn't it just mop up CD fund remnants rather than dispose of them at ~25% discounts? After all, it has a much better idea than any external buyer of the value, upside and exit possibilities.
Jonathan Sinex had no good answer to this and airily claimed CPV legally wasn't allowed to. A roomful of naive retirees might believe that, but I'm sure CPV could do so if it really wanted to. Specific structures differ, but this method is known under the umbrella of "GP-led secondaries" (aka continuation funds) and currently make up 40-60% of the secondaries market (and have over 23,000 results on Google!). The truth is that CPV's reputation isn't going to suffer much from the CD Funds selling stale portfolio remnants at ~25% discounts, so there's little value to it in providing Australian investors a backstop. The CD Funds are a "fund of funds" model with retail clients that isn't continuing. It's very different to keeping on-side institutional clients like pension funds. It's just one more piece of evidence that naive retail investors are disposable tiddlers at the bottom of the PE food chain.
Q. Can better periodic reporting close the "Information Gap" and attract demand nearer NTA and close the discounts?
K2 has taken commendable steps to increase useful, objective data about the CD Funds (Monthly & Quarterly Reports, Oct 2023 Webinar, Jan 2024 in-person unitholder presentations with Jonathan Sinex) but there has been little impact on the discounts. So far, the new data is of most value for current holders. However, the problem with lack of new demand near NTA in Closed End structures requires further actions, and it doesn't seem like K2 or CPV will pursue these for the CD Funds at this stage.
I have tried to offer my insights, but have run into barriers: confidentiality agreements supposedly prevent essential disclosures that might attract large buyers nearer NTA. Liquidity at efficient, informed pricing in the CD Funds doesn't necessarily benefit me, so I have no motivation to keep wasting this effort on behalf of retail investors.
Q. If CPV and K2 really want to attract large on-market buyers of CD Fund exposure, why not ask them about critical factors like the Information Gap?
I'm just a minnow in the investing world, but often have up to a million additional dollars available to put to work in ASX CEFs. I've read and understood every single monthly/quarterly report, presentation, webinar and annual report, but I haven't made any significant purchases of CD Funds in well over a year, and only consider doing so at exceptionally large discounts. I know other ASX CEF private investors in the same boat. There is an enormous Information Gap compared to trading ASX CEFs comprised of listed stocks (including microcaps where liquidity and efficient pricing is low).
Unfortunately, CPV and K2 have made no effort to contact potential large buyers (directly on the ASX) of such private equity exposure and ask what kind of information would give them confidence to bid closer to NTA. Instead, only off-market, whole-of-portfolio sales at deep discounts (~25%) are being considered. This just benefits industry insiders at the expense of retail unitholders. And these insiders do get to cross the Information Gap and find out exactly what they are buying!
Below is an email I sent to K2 before the Oct 2023 webinar discussing this. At the time, no information on a single company the CD Funds owned was published at all! After this email, Portfolio Companies logo pages were added (not complete listings though), but without some idea of weightings, potential large buyers can't even make a start on assessing the CD Funds closer to true value.
The more you close the Information Gap (e.g. after weightings, then profitability/growth metrics), the closer the few prospective buyers will bid to their assessment of true value. This is just obvious, but seems to have been placed by CPV and K2 in the "too hard" and "nothing in it for me" baskets. That's very disappointing as it demonstrates a lack of understanding of the deficiencies of Closed End funds and what's actually required to properly manage them. Alternatively, CPV does understand but doesn't care, even though it set up the CD CEFs.
CPV, K2 and other fund managers and responsible entities would do well to properly read this CaptiveCapital site before taking significant decisions regarding Closed End funds in Australia. And, twice over, if ever considering launching a new ASX CEF! Having gone to the trouble of explaining the problems in detail, I now take no prisoners on this site, and will continue to police the ASX CEF sector indefinitely.
Q. Are published NTAs and discounts for the CD Funds a sufficient or consistent gauge of value?
No, it's complicated. In the recent presentation the discounts at 31 Dec 2023 were listed as: CD1 (26%), CD2 (30%), CD3 (24%). Well if just reporting rolled-up valuations from the managers of the sub-funds on which they charge their fees and present their Internal Rates of Return that's one thing. But it doesn't reflect the true picture and variation for Australian investors.
For example, CD1 is in its 12th year, the remaining companies are hard to sell, and Jonathan Sinex in his presentation revealed that Cordish Private Ventures (CPV) "believes it is the right time to explore alternate liquidity options which may include a portfolio sale. Considerations will include any potential discount to NAV on a portfolio sale, the potential remaining upside in the fund, as well as the length of time expected for natural completion."
Well if the likely secondary discount to sell CD1 is circa 25% (my estimate) then the current 26% discount to sell your entire holding (unless it's very large) looks good value given distributions at NTA will likely be small and sparse and upside revaluation limited. K2 should now put an asterisk on the Monthly CD1 NTA advising of CPV's current estimate of the secondary discount.
Conversely, CD3 has a published 24% discount but is at a much earlier stage of the PE lifecycle and, based on Jonathan Sinex's views during the presentation, CPV isn't at all interested in a secondary sale at this stage (likely even near NTA!). Meanwhile, CD2 sits somewhere in the middle: some upside more likely than CD1 and probably greater proportionate distributions expected at NTA.I don't have the time to try and summarise here the numerous tax pitfalls but it would be remiss not to mention the big one: the CD Funds are at different lifecycle stages, have made differing profits, and their future distributions will have significantly different levels of tax-deferred (i.e. tax not payable) components. Remember, they are self-liquidating and ultimately return ~$1.60 in capital which isn't a taxable gain.
It's vital all CD Fund unitholders (and definitely any prospective buyer) is aware of this variation in tax-deferred proportions as it makes a substantial difference to the value of each fund after-tax. Australian retirees who can hold CD Funds in pension accounts not subject to tax should also consider the relative value of CD Fund distributions can be much greater than for Australian investors who are subject to tax on distributions.
Q. If the CD Funds are invested in companies that are profitable, why are virtually no profits distributed regardless of how mature the companies are?
The 31 Jan 2024 CD Fund Series Presentation lists Average age of remaining companies as: CD1 (7.4yrs), CD2 (6.7yrs), CD3 (4.5yrs). The presentation contained a slide showing "2023 Exits and Valuation Uplift" that argued the 30% average uplift from 6 months prior demonstrates the potential inherent value in unrealised Fund positions.
I can imagine an income-focused retiree invested in CD1 or CD2 might hear that there is no rush to fire sell the remaining firms as they are mostly profitable, and wonder why they can't then get distributions of these supposed profits while they wait? After all, the average age of remaining CD1 companies is 7.4yrs so presumably some of them are not re-investing all profits.
Unfortunately, that's not how the private equity game works! All the incentives are against profit distribution to investors, and excess profits are still reinvested, service or reduce debt, or used to pay fees and expenses. Private equity refers to this as "capitalising income" in order to delay tax and pay lower CGT rates. The aim is that a future realisation or portfolio sale will recognise the value of profits reinvested or utilised. But there is no transparency, and this is one area where the fanciful PE stories about all these profitable private businesses break down.
It turns out that naive investors can own these supposedly profitable companies for years but have no access to their profits. After waiting years longer than expected, then they're told the GP advises selling the remaining portfolio at a 25% haircut! Don't worry though, according to the experts, "long term performance of U.S. PE continues to outperform public markets"!
All active management beneficiaries make these outperformance claims about private equity. They might want to familiarise themselves with the VTI (Vanguard Total Stock Market) ETF and its 0.03% expense ratio. Below are its long-term returns in U.S. dollars. Notice how the investor's TSR is virtually identical to the return from the profits (and valuation) of the portfolio of listed businesses as there aren't a thousand cuts into returns, just a tiny 0.03% expense ratio (all that's needed to get the asset exposure).
Over the life to 31 Dec 2023 of the CD Funds, currency depreciation boosted the AUD returns even further, as I show in my Sharesight NTA and TSR comparisons. I encourage all CD Fund investors to use Sharesight to compare their Total Shareholder Returns against the public markets represented by VTI (or similar U.S. index ETFs). You'll find out who's telling the truth.
Q. K2 is applying to get CD3 and CD4 rated so they have the potential to be added to platforms like CFS, BT Super, Netwealth and Hub24. Will this generate more demand like there is for PE1 (Pengana's private equity CEF)?
This would have been useful at the start of each fund but by the time it comes to fruition, will likely only have potential value for CD4. But CD4 can't be traded except by complicated, ad hoc off-market arrangements.
Q. What are the annual fees and costs payable for the CD Funds? Do the funds have a fixed lifespan? How do these incentives affect the decisions of K2, CPV and the Underlying U.S. Fund Managers on realisation timeframes and winding up?
While there is no formal, fixed lifespan, the GP fees for each CD Fund were set to expire after 10 years, which indicates the planned lifespan. This matches the guidance given on the lifespan of the CD Funds in their PDS documents. Below is an excerpt from the CD1 PDS:
Note: CD1 Investment Manager (aka GP) Fees ceased in June 2022. CD2 ceased in Feb 2023. CD3 will cease in 2026.
Below, I've compiled the Fee and Expense excerpts for all 3 listed CD Fund fees from their PDS documents. You'll note for CD1, disclosure started out basic, had errors, and was actually missing categories like Other Expenses! By CD3, it's lengthy and full of fine print footnotes. But the biggest addition was the new performance fee at GP level.
Total Ongoing Costs of the funds were estimated at: 3.93% for CD1, 4.36% for CD2, and 3.35% for CD3. Well we can add the missing .4% to CD1 (Underlying Fund Management Fee error - see screenshot below) and it was 4.33% + Other Expenses. CD2 was 4.36% + Other Expenses. (For CD1 and CD2 the 2% GP Fees ended in June 2022 and Feb 2023).
As for CD3, as a proportion of final net assets, Accrued Performance fees were $14.8m / $155.2m (9.5%) in 2022-23 and $12.1m / $166.3m (7.3%) in 2021-22. So the 3.35% CD3 PDS estimate that somehow excludes performance fees is ridiculous.
Also, the "Investment Manager (GP) fees" are not included in the Annual Report Expenses for each fund, which deceptively has a "Management and administration fees" line item (actually just Responsible Entity and Admin fees) but no line items for the much more substantial "Investment Manager Fee" and "Performance Fee". For CD3, thr Investment Manager Fees were $1.12m in 2022-23 and $1.1m in 2021-22.
For 2022-23, CD3 Total Expenses in the AR Statement of Profit and Loss were listed as $1.6m. Yet, once we add $1.12m in Investment Manager Fees and the $2.7m yearly gain in Accrued Performance Fees, these dwarf the headline "Total Expenses."
In future, I am going to publish Annual Report extracts and decompose exactly where most of the gains from private equity typically go (Hint: Not to investors!). For now, I will just note that the "Underlying Fund Management Fees" are ongoing, undisclosed each year, and usually higher than the 2% estimate (definitely so if performance fees are applying). The cessation of GP fees for CD1 and CD2 definitely affects GP and CPV preferences regarding winding up and a secondary sale. K2's responsible entity and admin fees are ongoing.
Q. Should retail investors ever be invested in private equity funds?
No, there are too many pitfalls. In future I will post the best articles/videos I can find to explain why.
In brief:
a. The Total Expense Ratios are enormous and overwhelm any asset class advantages such as the illiquidity premium.
b. Low-cost index exposure to public equities beat private equity returns (see VTI benchmark above). IRRs, MOICs and other measures are irrelevant. For investors, TSRs are all that matter.
c. GPs invest only ~2-3% in each fund but extract fees of 2% of the fund each year plus expenses plus performance fees. GPs actually make most of their money from simply raising capital and locking it up, not some "secret sauce" of organically growing private businesses.
d. Performance fees are the typical heads I win, tails you lose story.
e. Fee calculations aren't disclosed and the extent of performance fees are typically hidden from investors. "Carried interest" details and variations are critical but never disclosed.
f. In a Fund of Funds model the fees are stacked on each other, Typically a considerable part of the stacking is unjustifiable (e.g. fees on cash or assets not directly managed).
g. Valuation mark-ups and mark-downs can be gamed for the interests of PE firms (e.g. raising capital for new funds). PE firms really do mark their own homework!
h. Diversification benefits are largely illusory given underperformance in the long run. The only beneficiaries are savvy traders due to valuation lags. Institutions like pension funds enjoy the artificial stability or reduced correlation but this is not a net plus for retail.
i. Leverage is possible at every level (fund, sub-funds, buyouts) and enables GPs to amplify capture of performance fees in the winners but also drives many portfolio companies to failure or zombie status. The failures majorly impact investor returns but there's no clawback of fees or expenses (including performance-related incentives paid).
j. Middle market private equity funds make most of their money by providing liquidity to founders/owners, and relying on EDITDA valuation multiples expanding (roll-ups, diversification, de-risking elements like key-man risk). Leverage juices the return.
k. It's intentionally kept opaque and complex. At different layers there are performance incentives, bonuses, preferred returns and various other cuts in the pie before any scraps fall to retail. Retail investors really do eat last.
See:
> Jeff Hooke: The Myth of Private Equity (YouTube)
Links:
> CD Private Equity Fund Series
> Cordish Equity Partners: About (inc 2012 partnership with Walsh & Company Asset Management)
> AFR: Dixon Advisory’s collapse delivers a painful lesson for investors
> AFR: Dixon downfall spells ‘danger’ for rival wealth firms
> Moonfare: Understanding the ins and outs of private equity distributions
> The Long-Term Investor: Warren Buffett: Private Equity Firms Are Typically Very Dishonest
