Zooming Past Covid-19

Caught in the throes of one of the most severe pandemics of all times, zooming past Covid-19 seems a distant fantasy. An un-coordinated global response to a systemic health crisis in the absence of a definitive medical cure and inadequate health systems across developed and developing economies, leave all mankind wondering, “how much longer, how much more and what’s next” ? While everyone is seeking answers, what continues to zoom however, is the virus itself, across geographical boundaries devouring hundreds by the day. In response, what’s also zooming besides Zoom Video, is human ingenuity in dealing with the mother-of-all crises and humanitarian gestures of healthcare workers, essential servicemen, grocers and many others on the frontline, going beyond their call of duty to help one and all. While the former zoom is repugnant and the latter laudable, the markets swoon and zoom is nothing but emotional amidst all round uncertainty.

Without any clearer crystal balls, many sanguine spirits spring from the Fed who has zoomed into action with powers of all super-heroes combined, cutting across every facet of business and finance like never before. Much that we would like to hope that the current overdose of the GFC prescription is going to rid us of all our economic, business and investment woes, and lead us to a path to recovery, we cannot help but zoom past the palliatives offered to find ourselves swimming in an ocean of uncertainty, more than what we were gradually getting immune to over the last few years. Agreed that global central banks led by the Fed have thrown the kitchen sink at capital markets to arrest the health crisis from becoming a liquidity and solvency crisis worsening the economic rout, far too many things remain in flux. Guilty of being worry warts, our conversations with investment managers around the globe, some peer-leading investors, think-tanks, etc. leave us thinking, questioning and worrying about issues of epic proportions some of which we discuss below (in no particular order) which have broad ramifications for diligencing global investments overall, as this crisis levels the fragilities/vulnerabilities of developed and developing markets. We apologize for this lengthy exposition but the issues at hand are far too grave to truncate.

Policymaking: Epidemiologists opine that the pandemic demands a unified global medical response encompassing testing of practically every individual, discovery of vaccines and drugs, contact-tracing, and herd immunity, beyond just social distancing. As many experts have vehemently voiced, coming out of lockdowns prematurely, even in phases, in the absence of any of these measures and reliable data, is exposing ourselves to future waves of infection threatening more lives with little economic gain, as unnerved consumers, businesses, and investors would hesitate to revert to life as usual. Also, if there are multiple shutdowns to combat infection rebounds, we would be socializing that cost further, every time.

We wonder if governments on their own or with external aid (IMF etc.) have the political will to shut their entire economies till we have a more solid medical response system to radically overcome this human crisis risking economic ruin in the interim. Though first order of business is to fight the crisis at hand, how would public health policies and systems develop and coordinate globally, to prevent, combat and contain future infection outbreaks from becoming epidemics or pandemics? Will rebuilding of grossly under-built health systems create an opportunity in healthcare infrastructure?

Fed Almighty: Unprecedented quantitative easing post-GFC by the Fed, ECB, BOJ evoked concerns as to how it would all be unwound to restore economies and markets to self-sustainable health. No sooner had quantitative tightening begun than, we found ourselves intertwined with central banks in virtually every aspect of finance with the Fed acting as the ultimate buyer of treasuries, corporate (IG and HY) bonds, commercial paper, muni debt, etc. and extending itself as the lender of last resort to banks (domestic and overseas), dealers, and even businesses.

With central banks acting in concert with governments’ fiscal stimulus, can this or will this ever be undone independent of political interference? Or do we live in an indefinite period where central banks pegged to politics will remain the central driving force for economies and markets, where no fundamental will matter and by extension “diversification” for investors will become a relic of a bygone era- a glimpse of which we saw post GFC? Equally concerned, we wonder if BIG government working through its central banking partners, is here to stay to prop up businesses posing a moral hazard and how likely would it invade our privacy (surveillance?), freedom and free markets?

Unlimited Leverage: What was once an over-levered (sub-prime) US household sector before the GFC, gave way to global corporations of all stripes (YoY 2019 debt raisings by developed market corporations: IG up 5%, HY up 50% source: Bloomberg) borrowing to the hilt in an era of lower-for-longer returns feeding a frenzied chase for yield. Now the ensuing economic downturn brings forth a day of reckoning for the weakest i.e. concentrated positions in BBB borrowers, unleashing a wave of ratings downgrades, defaults, bankruptcies and insolvency-a salivating recipe for distress debt investors. On the flip side, the lower- for-ever interest rates now usher in unlimited borrowing by governments who are absolved of leveraging up as subjects of Modern Monetary Theory. Stronger corporations are also following suit as debt service costs fall rock bottom and with Fed’s unfailing backstop, even high yield issuers are making a beeline to raise new debt.

With exploding global debt on balance sheets (300% of Global GDP, Source: BIS), will debt metrics now become the sole focus of all fundamental equity or credit analysis (to the extent it matters) and what debt metrics (net debt to EBITDA, debt to equity, etc.) will be relevant? With weaker credits falling out of favor with banks, will/should private debt rush to fill in the vacuum to respond to a bigger cry for yield that co-exists with impaired risk-taking abilities of investors? How is private debt (across performing to stress to distress) going to be priced when business models are upended, supply chains distorted and liquidation valuations of collateral rapidly becoming a guessing game? Can private debt still command decent risk-adjusted premiums for providing urgent, flexible capital, when business economics might be stretched to service the alternative credit? Will covenant-lite packages teach hard lessons? Last but not least, will banks that present themselves as safe harbors this time around with fortressed balance sheets, continue to maintain their standing when net interest margins are eroded, fee income is hardly an offset, delinquencies rise and capital buffers depleted by increased lending in compliance with central bank policies (unless they retrench to the advantage of private debt providers)?

Inflation-Deflation: Economists at the San Francisco Fed and the University of California in a recent joint study find that pandemics usher in a low growth/deflationary environment (leading to recession or even depression) for three to four decades as demand is destroyed, investment sags and savings increase. Wars on the other hand require rebuilding of infrastructure to restart economies creating increased economic activity that could trigger inflation. While Japanification i.e. deflation is a lurking threat, some economists argue that pent up demand once restored will precipitate a wave of inflation as supply might not quickly turn back on to meet demand or further still, increased infrastructure/stimulus spending could stroke inflation. Also, governments might be motivated to inflate their way out of their crushing debt burdens.

With some jobs expected to be lost forever (due to skills degradation, expedited automation, etc.) will demand i.e. purchasing power return as people regain their confidence to lead their lives as normal? Or will re-configured supply chains closer to consumers, deprived of comparative cost advantages of globalization drive costs higher? A normal economic cycle disrupted, will monetary policy makers lean deflationary or inflationary and what would it mean for asset owners’ asset allocations?

USD Rules: If it’s a race to the bottom by central banks prioritizing preservation of business/commercial activity over their currencies, the USD despite rock bottom interest rates flouts all conventional wisdom to remain the most coveted global currency (as witnessed by the negative cross- currency basis swap rate till the Fed intervened by opening dollar swap lines with developed and emerging market banks). Critics argue that the fundamental erosion of the US economy as depicted by rising fiscal deficits propelled by unlimited borrowing, will eventually weaken the USD. In the absence of another reserve currency of the dollar’s safe-haven stature (and crypto currencies ruled out from producing suitable alternatives), it’s hard to imagine a world where the dollar would be threatened off its perch when 60% of global reserves and 45% of international payments are denominated in US dollars (Source: Financial Times).

Will local currency debt (of say Indonesia, 33% held by foreigners-Source Bloomberg) be viable anymore? Or what level of other local currency asset returns justify the cost of dollar hedge?

Emerging Markets: Emerging markets, led by Asia will continue to boast as home to over 85% of global population. Its drivers of global consumption, urbanization, innovation, etc. will continue to command global investor attention but the need to distinguish between EM victors and vanquished across regions, countries, businesses and markets is more than ever before as countries vary in their fiscal response (e.g. Mexico -weak, India bold) to the Covid crisis. At the economic level, foreign exchange debt burdens (~$11 trillion led by Sub-Saharan countries Source: Brookings Institution) suffer in the wake of weakening local currencies, increasing external aid, declining forex revenues (from oil exporters e.g. Mexico, Russia, Nigeria etc. and others exporters) and declining foreign exchange inward remittances by hordes of migrant workers (e.g. from India, Philippines). To add, close to 36% of external debt (Source: World Bank) is held by investors like hedge funds who are less forgiving/flexible in restructuring talks. EM banks like everywhere else, also face the threat of rising non-performing loans gumming up the financial system. According to IFC, prior to the COVID-19 crisis, more than 50% of small and medium size enterprises (SMEs) in EMs did not have access to appropriate financing in their markets, which is expected to only worsen (to the advantage of private debt providers), especially for countries in Africa where SMEs account for 60% of GDP.

At the grassroots, many EM countries are grappling with the difficult choice of losing lives to hunger and poverty or to the deadly Covid-19 as most workers in emerging markets work in the informal/unorganized sector (e.g. 60-70% in India), with little access to government safety nets. Abandoning just-in-time inventory management and seeking more reliable local supply sources, especially medical supplies, (both painful lessons from the current crisis), might disrupt manufacturing hubs for many countries likes Vietnam, Bangladesh, etc. that had become low-cost producers for the developed world. In fact, in India itself, retailers are using apps (e.g. Mobisy, Jumbotail, Udaan) to place orders with distributors and brand-name consumer companies in their bid to make supply chains resilient. In a survival-of-the-fittest world, it is not surprising that protectionism could gain momentum (and globalization wane further) where scarce resources (e.g. rice in Vietnam, wheat in Russia, lithium from DRC) would either be disallowed for exports by populist governments or not be exported due to logistical challenges from transportation restrictions.

This begs the question how changing trade dynamics affects supply chain finance. Also, will labor practices put to test in the current crisis fail many companies on ESG considerations? Will aggressive accounting practices from the likes of Luckin Coffee and TAL Education in China, spill over into many other EM (and DM) businesses, feeling compelled to massage financial performance in a bid to mask Covid-ugliness? With growing income disparities will corruption rise and/or will it give rise to more authoritarian governments (e.g. Hungary, Poland)? Will investors holding EM sovereign debt be forced to take more than usual hair-cuts due to political backlash that governments could face from their constituents? Not only does this warrant a clinical assessment of businesses across multiple dimensions- business models, governance, valuations, etc., it necessitates a shift in focus to examining local idiosyncratic factors affecting businesses- demand/supply conditions, financial market health, execution, business practices, etc.

China-First Among Equals: Leading up to the Covid crisis, China has emerged as the indomitable force that is vying for global hegemony with the US. With US withdrawing from its global leadership as also witnessed in its failure to coordinate a global response to the pandemic, China appears as the savior to many in Asia (called “Health Silk Road” by Xi Ji Ping) and the western world, especially in Europe. To add, Europe’s fractured state as noticed in the sharp divide between fiscally prudent North (Germany, Netherlands) and the profligate South (Italy, Spain etc.), is further threatened, as evidenced in the North’s strong resistance to sharing additional debt burdens in the form of coronabonds issued by EU to rescue the weaker South. In such pressing crises, debt trap diplomacy that China has allegedly used with many African nations, could ensnare the predisposed, like Italy to embrace China, entrenching it further on the global stage, thus posing a risk to liberal democracies and global security among other things. To add, over the years China has ramped up investment in its education sector (~5% of GDP) to enhance its productivity with an aim to move up the value-chain from semiconductors to artificial intelligence to robotics. Now, as other countries and their companies hunker down and slash corporate spending/capex, it won’t be surprising that China outshines others, becoming the envy of the world. From an investor’s standpoint then, would every business and investment decision, no matter where the underlying might be located, warrant an analysis from a “China, what-if” angle?

Corona Wars: While many conspiracy theories abound about the origins of the outbreak (including a frivolous finger-pointing to adoption of 5G or Bill Gates with vested interest in myriad biotech companies tasked with discovering vaccines), it cannot be ruled out that after the world has doused the flames of Covid-19, attention of China-hawks and many skeptics will likely turn to investigating the timing of the outbreak with the signing of the Phase One trade deal. Also, under the spotlight will be terms of the deal like “acts of God and pandemics”, that allows China to walk away from its import obligations. Ignoring invectives like “Kungflu/Wuhan Virus”, serious thoughtful minds have questioned how Hubei province (where it all began) managed to contain the disease though allowing it to escape its borders into the world. China, long doubted for its reporting practices is also likely to be questioned (as would other nations, but perhaps less so) about the authenticity of its data on reported cases and fatalities. And above all, it is quite plausible that skeptics would question the delay by “China-centric” WHO in declaring this a pandemic. Cynics may even draw a line connecting its Ethiopian leader and Ethiopia’s victimization by China’s debt trap diplomacy, to the extent of it excluding Taiwan (to escape Beijing’s wrath) from a special mention for a virus-containment job well done. In a nutshell, there is potential for escalating friction between China and the US and its allies leading to more retaliation in the form of tariffs, sanctions, restrictions on tech transfers, investment flows, etc. that we have witnessed in the last couple years leading up to the signing of the Phase One deal. As of the time of this writing, US has fired the first shot in the new corona war by suspending (its 25% share of) WHO funding. And then there are initial reports that US suspects Beijing of violating nuclear-weapons testing. A further erosion of trust is underway!

Though less transparently reported in the current mayhem, India too, is under domestic pressure to launch its own investigation into “carona-jihad”, where the outbreak and its spread is being linked to a congregation of global Muslim religious leaders assembling in India to propagate their faith, which their devout followers reportedly continue to practice in public gatherings in opposition to strict lockdowns-a Herculean task to achieve in a democracy of 1.3 billion people. Will this add to growing tensions in the Indian sub-continent, that is already aggravated by a misguided religious minority protesting against a Citizenship Amendment Bill to protect other religious minorities from persecution in the Indian sub-continent? Will this detract from India’s growth agenda toward a $5 trillion economy and becoming a viable alternative to China, especially when the world desperately needs one?

Cyber Risks: Having discovered a refuge in cloud technologies these past days, corporations’ new-found ease of conducting business remotely in the virtual world, could expedite innovation toward automation and migration of more businesses and services to the cyber space. Therefore, cyber security assumes urgent importance to fend off cyber-attacks/zoombombing (as experienced by many Zoom users) which cannot be ruled out. Will businesses (and managers) ramp up spending toward cyber protection and build disaster continuity/recovery plans, especially when their bottom-lines have been eroded and coffers raided by the Covid crisis?

Private Markets: One might think that private markets offer a relatively safer harbor than public markets in panic-stricken market sell-offs but it is not totally immune. For one, public markets’ shrinkage of portfolio value creates a denominator effect where private market allocations appear outsized, warranting rebalancing. That concern feeds into LPs’ decision whether capital calls for private market commitments should be honored or should they sell in the secondary market facing other demands on liquidity. With public market equivalents no longer representing good proxies for private market positions, valuation comes into question. Valuation metrics like discounted cash flows, etc. is distorted by unpredictable cash flows and original assumptions all over the map.

While limited partners should have their eyes peeled for calculations of post Dec 2019 NAVs (especially 2016-2017 vintages), will general partners be equally transparent and forthcoming in sharing valuation calculations with investors, as it relates to distribution waterfalls, hurdle rates, preferential rates, clawbacks? Will GPs increase capital calls to pay down subscription lines? Will LPs honor or default i.e. refrain from putting good money after bad? If LPs default on capital calls, will GPs turn to non-defaulting LPs or a subscription facility to support portfolio companies in need? If demand for subscription lines spikes, how will sub-line providers respond to this surge in liquidity need with defaulting LPs who backstop their sub-lines? If GPs defer capital calls as deals are put on hold, will there be outsized capital calls in 2021 that LPs would need to provide for?  For investors, it begs looking closely at general partners’ assumptions, pricing metrics for establishing new positions, especially when past track-records/vintages become less indicative in a new investment paradigm where many businesses are likely to change radically. For existing positions, discussions around hitting operating milestones, tripping/breaching covenants are equally important.

Though private markets continue to attract new investment dollars in the wake of the crisis, adding to rising dry powder levels for many managers, especially the larger ones, limited partners occupy as much a position in the driver’s seat today as GPs to ensure, GPs stay true to their knitting and not style-drift tempted by newer opportunities in stress/distress debt, special situations, venture buyouts, etc. In a nutshell, when GP due diligence assumes a greater significance, will LPs take comfort in existing relationships/known brand names or respond to a new investment era (for all managers, big or small, known or unknown) by screening managers with a toothcomb? Also, as the need to research and conservatively price opportunities increases amidst growing complexity, should LPs reward GP for their prized skills or bargain for lower fees to retain more of the gains in a structurally weaker return environment marked with potentially lower leverage (with CLOs dwindling)/more equity contribution? For GPs who cannot raise new funds and lack dry powder, are they in compliance with relevant laws/protocols if they resort to selling some underlying positions in the evolving secondaries market to redeploy into other attractive opportunities? Alternatively, will GPs step down management fees, if they were to extend the investment holding period on positions, they no longer want to sell due to adverse market conditions?

Profitable Ventures: Reeling under the WeWork debacle, venture investors’ call to pursue a “path to profitability” over “growth- at- all- costs”, became louder. With many business models upended (especially co-sharing e.g. Airbnb, OYO, Uber/Lyft, etc.) by Covid-19 and investors’ reduced risk-taking abilities going forward, this shift toward profitability is likely to gain momentum as investors evaluate existing businesses for successive rounds and consider funding newer VC funds. Moreover, IPO climate is likely to be cloudy for the foreseeable future and VCs who could support their valuations based on an eventual take out by SoftBank, the grand-daddy of all VCs, is retreating having suffered substantial markdowns (pre-Covid), lack of funding for its Vision 2 fund and political chaos at the top of the house. To add, VCs’ support to their underlying fledglings during a tough time, is going to be a true test of their value-addition beyond just a conduit for financing, which, should they pass, will bode well for their ability to attract promising/serial entrepreneurs. As valuations are reset along with venture investors’ risk -taking abilities, which VCs will measure up to LPs’ call for a path to profitability and value addition? How will VCs triage resources for their stressed start -ups with challenged business models and new promising ventures (e.g. telemedicine, robotics, gene-sequencing, etc.) at lower valuations (hoping for a repeat of a 2009 experience)? How will risk-taking appetite of entrepreneurs change?

Reduced Risk-Taking: As mentioned above, the Covid-shock weakens investors’ risk-taking willingness as much as that of businesses to invest in a bleak environment. While, Fed is omnipresent and has opened floodgates to buying everything and lending freely, investors this time are shell-shocked as their very lives, livelihood and future is threatened in a world turned upside down. Will people heal with time and regain their confidence, or will capital preservation grip their minds especially if social contracts (health/unemployment insurance, etc.) remain restricted?  Will this transform investors’ risk-taking mind-set to that of lenders/providers of capital? With reduced risk appetites will financial innovation by non- bank credit providers in leveraged structures as in CLOs, Mortgage REITs and the like, continue? (especially when leverage i.e. trading on margins, compounded liquidity challenges once again (as in GFC), only to be averted by a proactive Fed providing a lifeline and well-buffered banks).

Stakeholder Capitalism: As articulated in our last post “Environment for Social Gains”, the cry for stakeholder capitalism has gotten louder of late. Covid-19 crisis is a true test of those who have practiced what they have preached, by balancing their response to their employees, customers, society, shareholders, etc. Their effective delivery would also speak to their strong governance, which demands strong leadership in crisis moments.

Will investors, desperate to protect their sagging bottom lines and planning for a new investing era, hold managers and business leaders’ feet to the fire as a demonstration of their continued belief in working for all stakeholders? By extension, will LPs continue pursuing their ESG principles to meet their investment returns or reorder their priorities? In a difficult business and investment environment, will business leaders and investment managers take refuge under stakeholder capitalism to deflect their concurrent responsibility toward maximizing value for shareholders and investors?  Notwithstanding the indispensable role of human interaction as brought to light by the Covid crisis, innovation will create newer opportunities in the venture world, which could potentially eliminate the need for many lower-skilled jobs faster than anticipated earlier. How would this square with investors’ social goals? Lastly, and most pertinently how will LPs balance their push toward climate change as an existential threat to future generations with the more immediate need to solve for potential health crises that could erupt at any time threatening all of humanity?

And this is not all. There could potentially be more concerns and questions that arise with each passing day. Without getting bogged down by the litany of woes, or wondering whether a U, V, W, or L shaped recovery is in store, what bears watching for us as researchers, due diligence analysts and investors, is how matters discussed above and more, evolve over time to inform our views on existing exposures as well as on new tactical or strategic investment ideas. Biotech, enterprise cloud technologies, venture buyouts, private debt, digital infrastructure, long volatility strategies, Asian fixed income relative value, secondaries, etc. might all appear attractive. The “next-normal” past Covid-19 calls for (a) re-evaluating the original thesis and proposed execution of every existing portfolio exposure (b) while remaining nimble with lots of dry powder and (c) aligning with astute investors (individuals/teams not just brand names; beware style-drift and new opportunistic partnerships) who can seize unfolding opportunities with established networks, local knowledge and responsive execution skills, complementing their heightened awareness of market technicals (algorithmic trading, passive investing, dealer inventory, domestic buyers, etc.) and the rapidly changing macro environment.

ÊMA endeavors to zoom past the Covid-19 crisis to recognize the new realities of the next-normal in sharpening its due diligence skills to research investment strategies and local execution teams that can contribute toward LPs’ portfolios. We welcome conversations with LPs seeking help to address concerns as above in navigating these challenging times.

Yours truly,

Kamal Suppal, CFA

Chief Investment Auditor

April 16, 2020

The above content is intended for sophisticated audiences as in institutional investors or family offices. Readers are advised that any theme or idea discussed above is not an offer to buy or sell any investment.