The Bermuda Triangle
a new liquidity trap
The recent announcements of the need for the UAE to raise US dollar swap lines raises a red flag for global liquidity, since to date they have been the main cornerstone investor for most of the new illiquid products coming out of Wall Street.
The mark to model financing of US tech has been kept alive since Covid by financial engineering. The traditional Corporate/IPO exit has been replaced by ‘Private Markets’.
But they also need an exit, which has led to a series of ‘pass the parcel’ trades within the Private Markets, including continuation funds and new funds to capture private investors as a proxy for the IPO market.
A new angle that emerged at the end of last year was the Buffet Insurance Float trade, PE/PC companies started to buy insurance companies and then sell to them packages of their accumulated private debt, realising their performance targets and creating liquidity. For themselves.
These insurance companies then in turn sold the debt to related reinsurance companies in places like the Caymans, and Bermuda, where there are legitimate concerns as to the levels of assets to liabilities.
The illiquidity problem hasn’t been solved, it has just been passed around the system, allowing the intermediaries to clear their balance sheets, but not the underlying investors. Their liquidity remains somewhere in the Bermuda Triangle.
Before the war, there was legitimate concern about many parts of the Private Credit world, mainly because of the move to sell to private investors in a semi-liquid form and the associated problems with redemptions of illiquid assets. These still remain, but, to us, they point to a wider issue, which is the ongoing search for an exit strategy for the VC, PE and PC financial complex. A post-war world will need to deal with this.
Meanwhile, as I explained on CNBC this morning - and following on from points made in the May Market Thinking note, the current Asset Rich, cash poor situation for the UAE and other Gulf states takes them off the table as a cornerstone investor for the new products Wall Street needs to keep the whole liquidity band wagon rolling (click image to watch).
Donald Trump is not alone in looking for an exit strategy - the whole world of Private Capital is
Mark to Model
There was an old adage, made famous in the episode of the fabulous 2015 TV series Silicon Valley known as the Sand Hill shuffle, whereby the start up is advised that it is better to accept $10m at a $50m valuation for its series A than $20m at a $100m valuation. The reason is that if you don’t raise a series B at a higher valuation, then you are basically in a ‘death spiral’.
The message is that for the VC’s this is all about the perceived valuation as they sell to the next person in the chain. Traditionally that was either a corporate or an IPO and certainly in Silicon valley companies like Apple and Google have hoovered up large numbers of smaller companies as part of their Cap-Ex programme. As we discussed in a previous post ( A New ZAibatsu), Apple is 130 companies and Google 263. Meta is 90. Each one has been bought for cash or else equity in the bigger entity.
The self-licking Unicorn ice cream
This led to the concept of the Unicorn, where, by round 6 or 7, the latest $50m or so goes in at a $1bn+ valuation and Cross-over funds, like Tiger Global push the IPO to even higher valuations, winning both sides of the IPO, creating profits in the illiquid and then the liquid parts of the business. As long as the IPO worked.
At this point it’s perhaps worth a little detour into the now somewhat forgotten episode of Silicon Valley Bank, (SVB) which collapsed so spectacularly in March 2023 in a classic liquidity mismatch type bank run. At its peak, SVB was basically providing a one stop shop for over half of all Silicon Valley startups, offering mortgages for founders, payroll and bank facilities. Most important, it provided so called ‘Venture Debt’, advancing loans backed by the collateral of the shares valued in the VC rounds. They also provided short term loans to VCs to invest in start-ups without waiting for cash from their investors.
It was, as the expression goes, a self-licking ice cream. VCs, flush with cash, invested in startups with an escalation ladder for valuation, while banks like SVB enabled participants to extract value via debt. The debt would be paid off by selling to a corporate or an IPO.
Tiger Global and SVB marked the end of an era
This all fell apart when the era of free money ended in 2022. The problem SVB had was that, during the pandemic, start-ups, now flush with VC cash, put their money on short term deposit, which SVB then invested in long term bonds. When the Fed started to raise rates in 2022 and the Ukraine linked inflation started to pulse through the system, bonds sold off, leaving SVB with some big losses.
Technically, SVB could avoid recognising the loss by claiming it would hold the bonds to redemption, but a flood of cash calls from start-ups broke that mechanism and the government had to step in.
Meanwhile, unlisted unicorns were marked down by a third, entering the down round death spiral, while Tiger Global linked IPOs like Coinbase, Roblox and Toast were, well toast, being marked down 70-90% and the IPO market basically froze.
Increasingly, therefore, without the IPO ‘bigger fool’ exit, it has been Private Equity/Private Credit who have stepped into the ‘value chain at the pre-IPO’ level, keeping the ever-expanding Indian Rope trick of valuations going. The problem is that, since SVB and the flight to liquidity, the IPO market is not offering the exits that many are looking for, which has led to the chain extending. PE selling to other PE, PC selling to PE and continuation funds - effectively a PE fund selling to itself.
The Bermuda Triangle
Which brings us to the latest iteration of the financial engineering, which is to borrow from Warren Buffet the notion of the insurance float. Owning an insurance company - as Berkshire Hathaway does - enabled Buffet access to a form of free money - the insurance premiums paid in need to earn a return to match their liabilities. Traditionally that has made insurance companies the main buyers of fixed income products, but if, as Buffet used to say, their holding period is forever, they can be put into equities.
Or, in this case, Private Credit. Several large Private Equity/Private Credit firms, the most high profile being Apollo, have recently acquired Insurance companies, which have, helpfully, been buyers of structured products designed to provide liquidity for the underlying PE/PC funds. The added twist is that those products are then sold on to (usually linked) reinsurance companies based in places like the Caymans and Bermuda, where the scrutiny over the asset liability provisions is considered more, shall we say, flexible.
With the Middle East not in a position to provide the cornerstone investment required for any ‘new’ structures and the Hyper Scalers committing to trillions in new AI infrastructure investment - a lot of which is also funded by debt - the liquidity needed to allow the financial engineers to crank the machine over one more time is looking elusive and if they are relying on reinsurance in places like Bermuda perhaps we need to be more worried than we appear to be……
Really enjoyed this one.