🎙️ High Finance

💭 Periodic paper losses in investing are the price of admission for having a decades-long time horizon saving for retirement.

But don’t be mistaken. Spending habits correlate with paper net worth.

When home values & stocks zoom, folks feel richer (the “wealth effect”), making them marginally more likely to buy brand names at the grocery store, splurge on a new car, or donate to charity — even if owning a more valuable house doesn’t generate more spendable cash.

On that third point, record charitable giving in the U.S. aligned with peaking asset prices in 2020-2021, only to fall nearly $60 billion year over year in 2022 as stocks fell and the housing market cooled 🔻

Our Chart of the Day visualizes this.

— Shawn

Here’s the rundown:

Today, we'll discuss the three biggest stories in markets:

• The big mistake private equity firms made with interest rates

• Softbank goes on offense to restore its legacy

• How remote work is reshaping the economy

All this, and more, in just 5 minutes to read.

CHART OF THE DAY

IN THE NEWS

😨 Private Equity Firms Fail to Hedge Interest-Rate Surge (Bloomberg)

The world of high finance, specifically private equity, evokes images of jet-setting savvy dealmakers with excessive generous compensation, immune to mortal misjudgments thanks to their extensive financial models.

Alas, they’re not so perfect: Private equity firms, which generally pool money from investors and allocate them toward stakes in private companies (those not listed on stock exchanges), have largely made a costly mistake in failing to hedge interest-rate risks in recent years.

• In English, the inflation surge in 2020/2021 that sparked central banks like the Fed to raise rates worldwide caught many private equity funds by surprise. This left them vulnerable to a spike in interest costs, threatening the financial health of the businesses they invest in.

Unlike most households’ mortgages locked into fixed rates, these companies issued floating-rate debt to finance their operations, meaning their interest expenses can fluctuate. When rates dropped quickly during the pandemic, floating-rate debt seemed like a slick way to exploit falling borrowing costs.

But investors should know interest rates can go both ways and prepare for that risk. Private equity (PE) funds could ensure those floating-rate debt obligations were hedged, effectively capping the interest rates on said debt with what amounts to a nominal insurance premium.

• Instead, many took the risk. Carlyle Group’s head of European capital markets commented, “Not many folks were worrying about this and a lot of businesses have been burnt really badly.”

Bloomberg estimates almost three-quarters of floating-rate debt taken out in recent years by PE-backed companies was unhedged, generating billions in extra interest costs that could push many into default, including around 300 medium-sized U.S. firms.

Why it matters:

This short-sighted failure not only costs investors but risks workers’ jobs at these PE-backed companies.

• Bloomberg notes, “Hedging was often an afterthought, and often hastily arranged.” One investor added, “Very few firms were focusing on this as an area of risk.”

It illustrates how inflation blindsided Wall Street. Many implicitly bet that the days of falling rates (“cheap money”), government stimulus, and benign inflation would endure longer, if not indefinitely, by failing to hedge floating-rate debt.

• Writes Bloomberg, “Deeply indebted companies caught flat-footed without interest rate hedges are having to play catch up — albeit at a much greater cost.”
  

• Interest costs at the median PE-backed company jumped to 43% of EBITDA — a measure of operating income — last year, six times more than the median S&P 500 company.

Unfortunately, hedging higher interest rates now is much more expensive, up to 200x more costly than before inflation started accelerating.

• In 2020, it would’ve cost around $55,000 to hedge a $546 million loan with a 3% interest-rate cap for three years. Today, the same protection costs closer to $11 million.

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💻 Economic Impacts of Remote Work ‘Revolution’ (NYT)

The pandemic made many people rethink their careers, passions, and ways of life. It also allowed remote workers opportunities to move cities, whether closer to family or to try a new region of the country.

• The consequences: shifting tax revenue away from large cities and new population dynamics.

In the first two years of the pandemic, one in four workers who moved long-distance was working remotely in a new home.

• Cities like San Francisco have been hit hard as more than 100,000 remote workers left the city in the first two years of the pandemic. More than 200,000 left New York City in 2020 and 2021.
  

• Many workers have said they migrated away from the most expensive parts of the country toward relatively more affordable major metros. Remote work helped accelerate that shift. The thinking: If you don't need to be in a big, expensive city for your job, why stay there?

The remote work revolution is expected to endure as a fixture of the U.S. job market. Specifically, some companies see offering remote opportunities as a competitive advantage or perk in recruiting talent. Many workers say they’re willing to take a paycut to work from home, as they save in commute costs (and time).

• It’s possible businesses theoretically reduce their payroll costs by offering slightly lower salaries offset by more flexible work arrangements, such as remote work or extra paid time off.

Why it matters:

For the expensive places that have lost remote workers, this means they have increasingly lost tax revenue and consumer spending power associated with high earners. During the pandemic, more than a quarter-million American workers moved to metros with a high share of homes intended for seasonal use — a proxy for places that are vacation destinations.

• That’s two and a half times as many as moved there in the previous two years. Nearly half of these new migrants said they were working from home.

The upshot: Remote work's ripples across the economy and the housing market are worth a closer look, especially as the dynamic plays out over the next decade.

• Housing costs in tax-friendly, warmer climates have soared. Big cities are eager to turn empty office buildings into housing amid rising remote work. And, as we wrote earlier this week, city budgets are being upended by the outflux of remote workers.

MORE HEADLINES

📈 Powell says he expects more rate hikes ahead as the inflation fight has “a long way to go”

⛽️ California is no longer the most expensive state for gas

🔥 401(k) plans have never been hotter

🤖 SoftBank Goes Back on Offense (Reuters)

It’s been a rough few years for SoftBank. In an emotional meeting with investors, its CEO Masayoshi Son announced plans to switch the Japanese company's stance to "offense mode" to capitalize on AI.

This comes after huge losses — $30 billion+ from March 2022-2023 — in its signature investment fund, the “Vision Fund,” spurred by its bets on emerging tech companies, which got hit hard last year as interest rates rose.

• Son admitted to making mistakes from enthusiasm about new technology and companies, disregarding valuable advice from within SoftBank, which led the company to take a conservative approach to capital management and investment risks.

On Wednesday, after five consecutive quarters of Vision Fund losses, Son said pointed to artificial intelligence for hope, saying AI could be the cornerstone of society.

• “When your grandkids are our age, I believe they will be living in a reality where the computer is 10,000 times smarter than the sum of all human wisdom.”

The company's new offensive strategy is evident in recent financial statements. Its cash and cash equivalents increased to $35.9 billion by the end of March, compared to $20.4 billion a year earlier, illustrating SoftBank’s efforts to raise cash to deploy en masse.

• SoftBank already has some substantial AI-related investments, namely in Arm, a British semiconductor firm designing high-end chips that power AI models. Arm's $10 billion initial public offering (IPO) looms on the horizon for SoftBank.

Why it matters:

Son, known for his successful investment in Alibaba in its early days, aims to establish a legacy akin to that of Steve Jobs from Apple, whom he’s admired for years. The launch of the Vision Fund in 2017 presented an opportunity to achieve this goal.

However, he encountered high-profile setbacks, including the infamous WeWork flame-out, prompting intense scrutiny of its finances and leadership from investors and the media.

• But embracing the transformative power of AI technology presents a chance for Son to redeem himself.
  

• Or, perhaps, it’s a reflection of the company’s desperation to dive into new tech with less-than-proven business models, doubling down on the approach that caused the Vision Fund’s gigantic losses in the first place.

See you next time!

That's it for today on We Study Markets!

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