September 23, 2019 • 39 mins
It isn’t a secret that pension funds, which we all rely on to some degree or another to pay for our retirements, are in dire straits. Ready for a scary number? The combined funding deficit of public pension plans in the U.S., across all 50 states, was reported at an alarming $1.28 Trillion in 2017. Thank goodness we have a savior! It’s the private equity business, right? But… what if it’s not true? What if private equity isn't going to make our retirement plans fat and happy? What if it’s only enriching the Wall Streeters who run these investment firms? In this episode, Bethany talks with Dan Rasmussen about the risks and realities of private equity.
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Speaker 1 (00:08):
I'm Bethany McClain. This is making a killing in this show.
I cut through the hype and handwringing to reframe the
stories you thought you understood and uncover the ones you
didn't know were important. It isn't a secret that pension funds,
which many of us rely on to pay for our retirements,
(00:29):
are in dire straits ready for a scary number. The
combined funding deficit of public pension plans across all fifty
states was an alarming one point to eight trillion dollars
in twenty seventeen. Thank goodness, we have a savior. It's
the private equity business. The belief, simplified, is that private
equity will invest in private companies or buy public companies
(00:52):
and take them private. Those no doubt brilliant investments will
play out perfectly and help us achieve the returns we
need in our health and retirement benefits will be secured.
The chief investment officer of the California Public Employees Retirement System,
which is the biggest pension fund in the United States,
recently advocated putting more money in private equity. His quote,
(01:14):
we need more of it, and we need it now.
He was a risk officer at Lehman Brothers. But anyway,
he's far from alan what insiders called dry powder. The
amount of uncommitted capital that private equity firms can invest
now exceeds two trillion dollars. But what if it's not true?
What if private equity isn't going to make our retirement
plans fat and happy. This is a question with huge
(01:36):
ramifications for pension funds, for those who depend on them,
and for our markets. After all, some private equity deals
have gone wrong in very public ways. Look at Toys
are Us, which buyout firms Bane and KKR, along with
Fornato Realty Trust acquired for six point six billion dollars
in two thousand and five. When Toys are Us filed
(01:57):
for bankruptcy in two seventeen, the toy company said it
had five point three billion in debt and was paying
four hundred million a year in debt service payments. Over
thirty thousand employees were left without jobs. In late June,
San Jose Inside newspaper published a piece noting that San
Jose's two pension funds hit up the amount they were
(02:19):
putting in so called alternative investments from less than ten
percent to almost fifty percent over the decade spanning from
two thousand and six to two sixteen. Over that same period,
those two plans posted returns that were consistently lower than
ninety nine percent of their peers. So there are some skeptics.
(02:40):
Chief among them is Daniel Rasmussen, himself an investor, although
that's probably too simplistic an introduction. Another investor has likened
Rasmussen to the fighter pilot Maverick in the movie Top
Gun because. In a very controversial piece published in American
Affairs last summer, rasmusen dismantles what he says are the
three assumptions that underlie the boom in private equity. One
(03:02):
that private equity firms make money by improving the companies
they buy. Two that private equity is less volatile and
less risky than public markets, and three that private equity
will significantly outperform every other investment. Resmussen writes there is
near complete consensus on these three points among academics, investors,
(03:22):
and private equity firms, and he believes that the consensus
is dead wrong. I have to admit, whenever I hear
the phrase near complete consensus, I get nervous too. So
I'm thrilled to have Daniel here with me to discuss
the risks and realities of private equity. After working at
Bain Yes, a private equity firm, and Bridgewater, a hedge fund,
(03:42):
Dan founded his own firm called Verdad Advisors. Dan is
also the New York Times best selling author of American Uprising,
the untold story of America's largest slave revolt. So, Dan,
(04:09):
what do you think when you hear the phrase near
complete consensus? The most dangerous thing in financial markets is
consensus because consensus is what drives bubbles. And I think
what's really frightening about private equity today is that over
I think a recent Prequin service at over ninety four
percent of institutional investors believe that private equity will outperform
(04:31):
the public equity markets by greater than two percent per year.
And yet you cite in the piece you wrote this
Cambridge Associate study that showed that private equity returns have
actually lagged the Russell two thousand index by one percent
in the S and P five hundred by one point
five percent a year over the past five years. Why
is there this gap between perception and reality? Largely because
(04:52):
the returns prior to two thousand and six were so good. So,
before private equity became the hottest asset class, it was
a relatively niche alternative. It was largely pursued by some
of the smartest people in the business, pioneered by Yales
and Dowmen and others, and it worked really well for
about twenty years. And in the late mid to light
two thousands, people started to realize how well Yale and
(05:16):
others had been doing in the asset class, and they
started to pile in. So all the performance stats that
people look at include this wonderful pre two thousand and
sixth period. Even though the post two thousand and six
period has been mediocre, it hasn't yet been disastrous. And
so people combine the mediocre returns the great returns. They say, ah,
where also are we going to look for something that
(05:37):
is a good chance of beating public equities? So, in
a sense are they victims of their own success? Of course,
and this is a perpetual story in markets. Everything begins
as a good idea and then Wall Street packages it
up and sells it, and if it keeps working, it
gets to be a bigger sales pitch, and the more
money that flows in, the more efficient the market gets.
And if more money keeps pouring in and the opportunity
(05:58):
set is small, that's where you at really bad market conditions.
So we've talked a lot on my show about Wall
Street being such a short term machine, and I'm always
interested in the places that seem to get exemptions. And
so why is it that people are willing to give
private equity so much credit for past returns that are
so long in the past. One of the great allures
(06:20):
of private equity. One of its big attractions is the
way that the returns are accounted for. So, because private
equity is private, the returns are calculated by accountants that
are employed by the private equity firms, who issue statements
on a quarterly basis saying what each company in that
private equity fund is worth. And those are highly subjective marks,
(06:40):
and they tend to track the financial metrics of those
businesses much more than they track the market. So in
Q four, for example, markets were down fifteen twenty percent
Q four eighteen, private equity marked down their portfolios and
aggregates somewhere between zero and five percent. Right, wow, So
either of these private equity guys are super geniuses who
generated fifteen percent of alpha in a three month period,
(07:03):
or the way they're marking their assets isn't truly to market.
And I think the reality is that they're not marking
them to market. They're marking them to what they think
they're worth. And that might be a very thoughtful, elegant,
intellectually correct way of valuing them, but it's not. The
markets are not efficient in that way. They're much more
volatile than they should be. And so because these returns
are artificially smoothed, people have grown lulled into complacency. And
(07:26):
there's always the case that someone can say, well, yes,
I know it hasn't worked over the past three years,
but it's early in the funds ten year. This is
a ten year fund. It'll be marked up over time.
It always has been. And these are the dynamics that
allow people to get fooled and lulled into complacency and
not get any feedback about whether their investments are working
or not. I think you used a line in your
piece that I loved that the CIO of the Public
(07:49):
Employment Employee Retirement System of Vitaho called this the phony
happiness of private equity. It always makes me. Think of
my favorite line from the Sun also rises? Isn't it
pretty to think? So? That's exactly right, Much prettier to
think so than to admit that these returns may actually
not be all they're cracked up to be. You had
a great example in the piece you wrote of this too,
not just the fourth quarter of two thousand and eight,
(08:10):
but what happened when energy prices crashed in twenty fourteen
and twenty fifteen. Do you want to walk us through that? Yeah, So,
you know, oil prices dropped more than fifty percent, maybe
maybe even seventy percent or something like that, and private
equity energy private equity had been it, you know, investment class,
which it is again now now for reasons that you've
(08:31):
documented very well, don't make sense to me. But these
private equity firms had bought a lot of shale drilling firms.
They levered them up much more than other investments in
the industry. Public energy stocks were generally down about fifty percent,
and I think at the time I wrote this piece
in the middle of twenty sixteen, the private equity assets
(08:51):
were not marked down at all, So they were marked
at one right, so they even the twenty fourteen and
fifteen vintages were marked at one. So they deployed a
bunch of money and highly levered very small shell drillers.
And even though the public equival was down thought fifty,
oil prices were down sixty or seventy, right, they were
marking them at one. There was one energy pe executives
asked you, why is it that your portfolios marked at one?
(09:13):
He said, well, we're looking through the cycle when we
make our valuations once again. Isn't it pretty to think so? Right?
I saw a quote actually that some eighty two percent
of people in private equity use internal valuations rather than
any kind of external benchmark. Why do investors let our
investors just so desperate to believe that it's in this
(09:33):
lack of volatility that they allow private equity firms to
get away with it? Yeah, I mean, I think we're
living in an age where everyone thinks back to the
pain of O eight. I mean, I think it's very
much on people's minds private equity. I think the Russell
two thousand small cap index was down about sixty percent,
peeked a trough and eight private equity was marked down
about thirty percent. And so if you're sitting there on
(09:55):
the investment committee of one of these pension funds or
college endowments. You look back at that experience and you
love private equity because that's what allowed you to sleep
at night during that period, or to tell your committee
that you were beating the market or you weren't down
as much as the S and P. Right, you know,
our and dowment did fine through the crisis. And of
course it was a myth. But it's a myth that
(10:16):
everybody is happy to believe in. I mean, markets are
too volatile, right, I mean, nobody likes it when their
portfolios down fifteen percent in three months, and this offers
a pleasant alternative. Why do you think it continues with
all of the warning signs that are building up to
be so easy to sell private equity firms, institutional investors,
It serves a pleasant fiction that a lot of us
(10:38):
would like to believe in. It's like your quote from
aus Son also rises. I think we'd like to believe
that very smart, well educated Harvard Business School graduates can
run companies better than other people, and that if we
meet them and we really vet them, and then they
go and buy these companies and they don't just buy
a piece of them, right that they buy the whole company,
(10:59):
and they really sit on the board and they work
really hard at it, and they can improve the companies.
David Swinson, who's the Yale endowment manager. So this is
a superior form of capitalism. Yes, it's just better. It's managed.
It's managed by just the type of people you think
should be able to manage it very well. Okay, so
we've addressed your first myth that these funds are not
less volatile. It's just the accounting that actually helps them
(11:22):
look less volatile, the accounting we're all actually willing to
buy into. And now there's this myth. One of your
other myths is that they actually can improve companies. And
you've actually done a lot of work showing that that's
not true. It's not just a belief of yours. And
what's the most compelling thing you've found that made you
say this just isn't true. What do I want to
address this question? It's hard because private equity companies are private.
(11:44):
So what I looked at is every private equity deal
where the company has issued public debt. Okay, so when
you issue public debt, you have to report your financials
at the time of issuing the debt, right, which is
when the transaction occurs, So you have the pre transaction financials,
and then of course you have to report to the
market what your returns are afterwards because the data is public.
So I found about I think three hundred or so
(12:06):
deals over the past a decade which I'd issued public
dat so it's a pretty broad cross section. And then
what I wanted to look at is pre acquisition what
the financials were, and then post acquisition and see if,
of course operational change is happening, and if it's happening
at a magnitude which is driving this very superior performance
to the public equity market. I figured it should be obvious, right,
(12:28):
I mean, I shouldn't have to look too hard. So
first I looked at trends in revenue growth YEA, and
broadly what I found is that revenue growth slowed post acquisition.
That's actually stunning, but it's not stunning if you think
about it in a different way, which is that private
equity firms want to buy good companies, so of course
they're going to select for companies that have been performing well,
which are going to be firms higher revenue growth than average.
(12:49):
But if the world reverts to the mean and there's
no skill, then you'd expect to see above average growth
in the past and mean growth afterwards. That's what you see.
And then you look at margins. So okay, well, maybe
maybe the private equity guys aren't driving revenue. Maybe they're
brilliant cost cutters, maybe their efficiency geniuses. There's such a
thing as being a brilliant cost cutter. Maybe Okay, aggressive
(13:09):
cost cutter, savage cost cutter, a predatory costcutter. I get it.
But I saw basically no change in margins pre and
post acquisition. So it wasn't like revenue growth was expanding.
It wasn't like margins were expanding. So what did change, Well,
very systematically, in every deal observed, there was a massive
increase in debt. And with a massive increase in debt,
a massive increase in interest payments, and because of the
(13:32):
massive increase in interest payments, generally a contraction and investment spending.
So if you think about what is the operational playbook
from a data perspective, the operational playbook is to add
debt to companies. That's it. That's the leverage buyout it's
private equits just a story of debt. It's a story
of debt. Does this make private equity sort of a
parable for our times in the sense that this is
(13:54):
the era of debt? Yeah? And I think that post
oeight a sort of a set of interesting things happen, right.
I mean, one is that interest rates obviously dropped a lot.
Two is that the FED really intervened to abrogate the
default cycles. There are fewer defaults in O eight than
there were, for example, in OH three, So I think
a lot of people got lulled into complacencies. They say, Okay,
we can take risks with debt because interest rates were
(14:16):
low and the Fed's going to bail us out, so
why not go down the quality scale, take a little
bit more credit risk. Surely it couldn't go wrong. And
that's large to what we've seen in private equities. So,
you know, the debt levels have just risen and risen
and risen and risen. And because of regulation, the banks
are no longer the ones public banks are no longer
(14:38):
the ones providing the stat financing. Now it's in the
private lending market, the business development corporations, the mid market lenders,
the clos this whole heave of alternative lenders that are
the ones providing this debt. And these are firms with
very little track record. They're new firms, they don't have
a lot of experience, they haven't gone through cycles. They're
very aggressive, and they're willing to lend to all our
(15:00):
companies more money than banks ever would have lent. And
they're willing to do it. And this is sort of
a very common thing that goes on in the industry
on ProForma financials. So the FED, for example, put it
rule in saying banks shouldn't lend a company is more
than six times IBADA. So what happened in the wake
of the crisis is that a lot of these private
lenders and mid market lenders said, Okay, of course we're
(15:21):
not going to lend more than six times EBITDA. But you,
the private equity firm, tell us what IBADA is right,
Because EBA does a made up number. It's not a
it's not a net income, it's not cash from operations,
almost whatever you want it to be, not quite exactly.
So it's called ProForma ibnore all the bad stuff, earnings
before all the bad stuff, and Moody has just done
(15:42):
a study on this found that proformat ibada was generally
about thirty percent higher than gap ibada, never lower. So
I want to come back to this because this seems
to hint to me at kind of round two of
the shadow banking system that played such a dangerous role
in the financial crisis of two thousand and eight. But
you you said something when you were mentioning the lack
(16:03):
of operational improvement to private equity firms that I found fascinating,
which you said that there it's actually less investment, that
they cut back on investment. And I find that really
interesting because part of the marketing of private equity is
that it's an escape from the short termism of the
market that by allowing companies to be in private hands
and to not have to meet quarterly earnings expectations, you
can invest more and you can allow companies to take
(16:26):
the big bets on businesses that we all want to
see them make. Your data would seem to suggest that's
not true. Lookt decreases your flexibility, right If you o
lenders a huge amount of money, right, you don't have
the flexibility to take some big, large scale bet And
these firms are not taking out debt to fund building
of a new factory. They're taking out debt to fund
(16:46):
the acquisition of themselves. So I think that just simple
logic would suggest that the firms that are going to
invest a lot are not the most levered firms. How
do you think about the returns garnered from the big
dividend payments that it be comes such a feature of
private equity because I might be wrong, but that strikes
me as new. So back in the battle days of
(17:06):
financial engineering, right, private equity firms didn't routinely do that.
They didn't add on debt and pay themselves a big
dividend and get their money out the way that happens
in so many transactions today. Am I right about that?
And is that a relatively new feature that is, yes,
contributing to what returns there are, but also potentially quite
problematic both for future returns and for the state of
(17:28):
these companies. Yeah. So this is going to come back
to the lessons learned from O eight, And one of
the lessons learned from O eight by the private equity
funds was that they bought a lot of things in
a six or seven and then they couldn't get any
money out of them until twenty ten or twenty eleven, right,
so they were had this long period where they'd put
cash in and they didn't get cash out, and that hurts.
The key performance metric for private equity is called the
(17:50):
internal rate of return right and time based, and it's
time based, so you have to have a short window
between when you put capital to work when you return it.
And so all the IRR on the oh six and
oh seven vintage funds were really low, and so a
lot of firms convince convence study groups to say, okay, well,
what are we going to do to make sure our
RR numbers are attractive. And one of the things that
(18:12):
they came away with is that you need to return
capital early on in the investment. So you need to
shorten the time between when you deploy capital when you
give it back. So there are two ways to do that.
One is you take out a subscription line of credit,
so you buy a company, so you close in March,
you borrow all the money you need for the closing,
and then you wait until December to call the capital
(18:32):
from your investors. So you've shortened the investment period by
about nine months maybe, So that's a subscription line of
credit that you do on the front end with yet
more debt, with more debt, right, but it's short term debt,
so it's pretty low rate, but it really helps the RR.
And then the second thing is after about a year,
if the operational metrics are good, and usually if there's
anything you can generally forecast better, it's very short term
(18:53):
results right after you buy something. So you buy it,
maybe you make the quick fixes, ebit does up a
little bit, You go back to the bank, you say, look,
EVA does up five percent or timbercent. We can take
out tim percent more debt, and we're going to do that.
We're gonna refly at we're going to pair ourselves at
dividend and then they get cash back really fast. So
now their rrs looking great. And this has been it
can't be understood how important that those dividend payments are
(19:15):
to improving rrs. And that's really been one of the
big drivers behind this. But that's actually frightening because it
would suggest that the returns is meager as they have been,
are also being juiced by tactics that may not be
that are not sustainable. That's right, and hold periods. Actually
this is interesting. So the underage Slifer, who is the
most cited financial economist I think ever, and he says,
(19:38):
there are three ingredients to a financial crisis. It's consensus, leverage,
and illiquidity, and those are the dangerous trio. And obviously,
you know we have consensus here, we have increasing leverage,
and what's really scary is the illiquidity aspect of this.
So one of the ways the private equity firms, you
can think about measuring private equities, how long is the
(19:58):
average hold period? So they buy company and then they
sell it, and I think in O five and oh
six is average hold here is about three or four years, right,
So they buy it, sell it in three or four years.
Now the genius to fix it in the music, right,
they could do it that quickly. Now it's six or
seven years. Okay, So these investments have gotten a lot
more a liquid So that's another reason they're taking the
(20:19):
dividends out and they're actually holding them longer. So why
are they holding them longer? I would argue they're holding
the longer because they can't sell them. They can't sell
them at a higher peru, right, Hence the illiquidity right.
Another interpretation, which they would say, is we're holding them
longer because it just we're having such a wonderful operational
impact that we realize that just within another two years,
(20:40):
under our benevolent management, we could really turn the corner operationally.
So you can choose which your explanation. But I'm a cynic.
What can I say? Hey, one of the things I
find fascinating about you is that you're not criticizing from
the outside. How did working at Bain helps shape your views?
And did you know when you went into Bain that
you might become optic about private equity or did you
(21:01):
go into it thinking this is the greatest thing ever.
I'm going to be an operational genius who's going to
help transform corporate America. Yeah. I did think of myself
as a genius who is going to transform over to
America's I think many twenty one year olds do. And
I think that initially what attracted me to private equity
was I think the same thing that attracts a lot
of investors to it. I thought, Okay, here's a chance
to not only have the intellectual side of making investment decisions,
(21:25):
figuring out what a good company is, or what a
good industry is. But there's also this management. You know,
you actually own the company, so you can make a
difference and you can improve it. And wouldn't it be
great if you could make money by doing both at
the same time. And she look at the returns and
everyone smart thinks this is a good idea. Right, Go
talk to any college endowment. What do they do? They
think it's the best thing ever. And I was very
(21:47):
persuaded by that. And I think that when I started
doing more and more work, what I uncovered was not
that anyone's intentions were bad. I think generally these are
very smart, very well intentioned, good people, but that the
prices for assets in the private market, we're going up
and up and up. And because the private equity models
(22:07):
to lever everything at sixty five percent, if you go
from paying seven times cash flow to ten times cash flow,
that means you're going from putting four times cash flow
of debt to six times cash flow of debt. Well,
and then you go to twelve times fourteen times. You know,
the higher you go, the more debt you're putting on it.
And when I started to realize, we looked at a
huge data set of historic private equity deals. Was that
(22:29):
those expensive deals, because of the large amounts of debt,
had unusually high default rates and we're on unusually bad investments.
That most of the money was made buying the cheaper
investments right where you're putting a reasonable amount of debt on,
which seems logical to me. And this is also why
people criticize financial engineering, because back in the eighties and nineties,
financial engineering ment buying things really cheap and funding the
(22:51):
purchase with debt, which I actually think is a great
way to make money, right, you buy cheap things with
debt makes a lot of sense. Expensive things with debt, right,
like whether that's a yacht or a company or a diamond.
You know, you know it's not going to work out
so well. And that's was very observable in the data.
And when I started to see that data, I said, well,
this doesn't really make sense to me. And that was
(23:12):
in twenty eleven, twenty twelve. That was the moment of
your conversion from the lever to skeptic. Well, and then
since then purchase prices have gone up another twenty percent,
So you know, I was skeptic probably too early, right,
But things have only gotten crazier and debt levels only
gotten crazier. Why is it that, given that data doesn't
usually lie well, I guess depends on how you interpret it.
(23:32):
But the data seems so straightforward and so obvious in
the logic seems so obvious. Buy something cheap, it's a
lot easier to make money than if you buy something
that's really expensive. Why won't the industry see it? I
actually loved this statement that Bain made about your criticism
of the industry. Mister Asmussen was a junior member of
our team during his employment without full insight into our
investment process or operational value. Add Yes, I hope to
(23:57):
meet someone with full insight someday, but I have with
operational value speaking, I have cynicism value. Add perhaps that
I think I think that's a better thing. But I
think that there are a few things have gone on. Right.
One is this lack of defaults. So's there have been
an unusually low rate of defaults over the past decade. Right, So,
(24:17):
bad lending behavior has not been punished. Okay, buying really
junky private credit assets has done. Okay, it's done. Okay,
it hasn't defaulted. And because so much more of it
is in private hands. The private people don't have as
much of an incentive to push stuff into bankruptcy. It's
not as visible when credit and stats are deteriorating. There's
(24:37):
this extend and pertend philosophy. So because of that, the
bad things in private equity portfolios have not gone belly up. Now.
There have been a few public exceptions, right, which we
can talk about, ye, a few of the big public exceptions,
but a lot of them have become sort of what
I would call zombies. Right. These are the firms that
are dragging the whole periods longer and longer. Right, So
(24:58):
they don't default, they don't go bankrup they just stay
in the portfolio. Right. I even heard one large private
equity manager come out and say, the thing I'm most
proud of about my firm is that we've never lost
money on an investment. Right. Amazing. And I said, well,
what percent of the companies that you've ever bought do
you currently own? And he said about sixty five percent.
I don't believe you've never acknowledged that you've lost money
(25:19):
on investment, right, Right, But private markets allow you to
do this, right, so you can hold on longer than
the equivalent public asset, you don't have to pay the piper,
and in time of low defaults, you really don't have
to pay the piper. And then if you look at
what's happened in the public markets, that there's been a
huge premium for growth, right, So anything with high revenue growth,
high sales growth has done really well and has been
(25:39):
valued it really insanely high prices. So you've had a
corner of the portfolio, which is the very expensive but
very high growth things that actually have been great investments. Right,
You've been able to buy them at a really high
price to flip them in your sale for a period
of time, and so you've got this contradictory lesson. Right
on the one hand, you're saying, look all the stuff
I paid crazy prices for I sold two years later
(26:01):
for an even crazier price, and look how much money
I made. And then yeah, I paid some high prices
for some other stuff. But you know it's still marked
at one and you know, our operational guys tell me
that next year it's going to turn the corner and
put up that up for market. Who knows what it's
going to be worth. So it's a bit of a
version of check prints the former CEO of City Group
who said famously, right before the financial crisis broke wide open,
(26:22):
as long as the music's playing, you have to keep dancing. Yes,
what's scary is to see these metrics, whether that's fundraising metrics,
So more money being raised, more dry powder, which leads
to higher purchase prices, which means to higher debt levels,
which means to lower credit quality of either debt that's issued,
which leads to longer hold periods. Right, every single one
(26:42):
of these metrics is deteriorating. There's not one that's not
getting worse. But it's all driven by fundraising. So despite this, right,
the fundraising is going in exactly the wrong direction. It
is actually causing a lot of this bad behavior. Because
I think people often talk about they say, well, look
there are five hundred companies in the five but there
are thirty thousand or one hundred thousand small companies in
(27:02):
the US. They're ripe for private equities, so it's a
much better market. But what they don't realize is that
it's a power law distribution, just like income. Right, Like
Amazon is worth ten thousand small companies, right, So the
actual market is much much bigger for these big liquid
companies and small companies, and yet the amount of capital
that's now chasing these tiny little companies is really overwhelming
that market. And I think you've quoted or at least
(27:24):
you've heard some private equity officials themselves expressing concerns about this,
worries about the sheer amount of money that needs to
be invested, but yet they don't stop. Yeah, well yeah,
I mean it is funny. I had at one point
I should find a series of quotes from KKR, Apollo,
Carlyle Blackstone, the heads of all these firms, saying this
(27:45):
is the hardest time it's ever been to invest. Our
Number one problem is high purchase prices. What's going on
in the debt markets isn't sane. I mean, they're very
open about it, they see it, and yet they're raising
bigger and bigger funds. And as some component of that,
not just their own belief in their own brilliance, but
also the fact that they're paid a management fee upon
those assets. So there's an incentive for asset gathering as
(28:09):
opposed to I mean, at what point, even with a
giant firm, does the incentive for asset gathering become become
more compelling than the incentive to to make good investments.
I don't even think it's it's them driving it. I
mean they're the beneficiaries of a massive wave. They couldn't
stop raising money if they tried. I mean I talked
to so many pension fund managers and endowment manages and
(28:31):
I say the same things. I said, Yes, why are
you doing this? You know, why don't you just press
pause for a little bit. And one of the things
I say was, well, she if we don't commit to
fund six, we're never going to be let into fund seven. Right,
So there's this It's not only fear of missing out,
it's fear of being locked out because right, because you
didn't stick with them for every single fund and so
(28:54):
and then they say, well, and markets have been going amps.
If we want to maintain a steady allocation to private
equity and this public markets went up twenty percent, we
need to increase our allocation private equity by twenty percent
versus what we committed to the last fund. Right. So
they're going to their managers and they're saying, we need
I know, you took one hundred million last time, it
can you take two hundred million this cycle, and which
private equity guy is going to say, well, no, we
(29:15):
you know, it's really not a good time in the cycle. Right,
They're going to say, oh, right, you want me to
manage four billion and so of two billions, so you're
a double my salary. You're almost making less. Say no,
you're almost making me feel bad. For these poor private
equity guys with all of these billions of dollars being
thrown at them, I mean, they're just helpless in the
face of it. Who could resist. One of the criticisms
I've heard of your work or your theory comes down
(29:37):
to this, which is that private equity may be dangerous,
but public markets are way more dangerous. How would you
respond to that? Yeah, I think public markets are more volatile, right,
so they feel more dangerous right where they or they look,
the volatility is more obvious or more real and right,
and that also enables bad behavior. Right, that's very easy
to sell at the bottom and buy at the top
and right, whereas private equit at least you're locking up
(29:58):
your capital into something for a long period of time
and you literally can't sell it. So maybe that's a
good thing. But I think when I think about risk,
I think about two primary forms of risk. One is
valuation risk, so are you just paying too much given
what an asset has been worth historically or relative to
other assets? And then I think second is credit risk,
so is what you're buying going to go bankrupt? Right?
(30:21):
So two very simple ways of thinking about it. So
for public markets, right, you could say, is their valuation risk? Yes?
In the US, yes, stocks are priced expensively relative to
long history, but probably not so much bankruptcy risk, but
not bankruptcy risks there's not a lot of debt. Right,
Is Apple or Amazon or Facebook going to go bankrupt? No? Right,
(30:41):
they don't have a lot of debt. They're not going
to go bankrupt. What's different with private companies? Right? Private
companies are a lot smaller. So the average private company
is actually about one tenth the size in terms of
market cap as the average Russell two thousand small cap companies.
So these are tiny, tiny little companies, and they're tiny
little companies that have probably about three to six times
(31:02):
as much debt on them as the average public company,
which is ten times bigger. Right, Right, So you're looking
at these tiny, tiny companies that are much much more levered,
and they're trading at prices that are twenty percent higher
than oh seven, I don't know. Both those things line
up for me, and I say, look, is it historically
risky as measured by historical volatility? No? Is it risky
(31:25):
as measured by the performance historically No? Both those things
suggest it's the best thing since slice bread. You shoul
put one hundred percent of your money in next it's
perfectly it's less volatile than bonds and as higher turns
than equities. But any prospective analysis that looks at okay,
but what are they actually buying? Right? That's what's scary, right.
And it's so interesting because going back to your point
about statistics, even if statistics often do tell the right story,
(31:48):
you have to be very careful about what statistics you
choose to look at, because the narrative you want to
hear can influence the statistics you choose to see. Right,
how dangerous is this is? I listen to that, I think, Okay, well,
the debt figures are really really frightening. At the same time,
if these are really really small companies, how much damage
does this do? If you're right in the bankruptcy risk
(32:08):
is big? How much damage does this do to the
financial system? The interesting thing about it, and part of
this was created by the FED saying, hey, this shouldn't
be done at banks, right, this should be done by
these private lenders and BDC. Did the FED actually say
that or did they just say this shouldn't be done
at banks without meaning right, right? Right? Right? Instead? Uh?
(32:35):
And so I think the impact on the economy, right,
So I think on the one hand, i'd say, look,
it's small, right, It really is a small It's a
drop in the bucket. But ben Burnank wrote his PhD
thesis on the small shocks big crises puzzle, right, So
small shocks calls big crises with some level of regular
some extent, right, And so I would say, look, is
(32:56):
it a tiny thing. We're alter the size of the economy. Yes?
Could it have an out sized impact if it impacts
how market participants act? Yes, Now where will the pain
be felt the most? I would say, I don't know
if it'll affect the economy. I don't know if it'll
affect the broader market, right, I do know it'll affect
people that own it, Okay, And who owns it? Pension funds,
pension funds and college endowments, some of whom are putting
(33:18):
thirty forty at the upper end percent of their money
into private markets, private equity, private debt, venture capital. Right,
I mean because of this institutional consensus, right, And I
think those are the people that are going to get
whacked by this, people who can least afford it, at
least in the case of pension funds. So it's right, right.
Do you think anybody understands given that the financing side
(33:40):
of this, the debt provision side of this, has become
so opaque, do you think there's anybody who understands what
goes on there? Is it possible to figure that out?
I think there certainly are the problems. There's no way
to short it, right, it's all private, yea. How do
you short science private? You can't, So there's no you know,
there's no gym. We don't have a big short yet. Right,
You can't really short it. All you can do is say, gee,
(34:04):
you know, I think you're a little crazy to be
putting money there, and then the person goes back to
and so public markets are down twenty last year and
our private equity port flows down five So you're the
crazy one, right, right. Is there any irony in the
fact that the very private equity firms that talk up
the benefits of private investing Blackstone, KKR, Apollo are themselves
publicly traded. It is remarkable, isn't it. I'm not sure
(34:27):
you'd think they could go private and then improve themselves.
Maybe that's what we'll recommend that. Maybe that's what we'll
get to actually, as when the private equity firms start
taking each other private in order to operationally improve themselves,
and then all the workers there, all the brilliant Harvard MBAs,
can figure out what it feels like to be a
line on right, and I'll reveal to them that their
models aren't very accurate, so they probably could use about
fifty percent fewer analysts exactly. Now, that would be a
(34:50):
perfect fictional ending about all this. So if you had
to predict this, does this end in a bloodbath? Are
just in disappointment and slow, sad disappointment for the pension funds,
as we've discussed, who need these returns the most. I
think it really depends on whether we have a default
cycle or not. So if we have a real default cycle,
like we had No Three, then this thing blows up right,
(35:11):
because all these things are not credit worthy. I mean,
and so if there's any change in credit standards from
extremely loose to somewhat reasonable, a huge percentage of this stuff,
you know, I'd say upwards of thirty percent of private
equity deals, and my guess would be going to default.
This stuff is really bad paper. However, standing number, I
(35:31):
think zombification is a real alternative, right, which is that
we just extend and pretend, right, so it just fizzles
and all of a sudden, you've got a fifteen year
old private equity fund that still has three investments that
are still marked at one that just hasn't sold, and
you're disappointed, but the rr still looks good because some
of the dividend recaps early on, right, I mean, I
think that's a really good and frightening phrase. Just tell
(35:55):
us quickly what you're trying to do with for dad.
My premise is that if you look at the early
years of private equity, the returns really were wonderful during
the financial engineering years, and there the two key ingredients
to that. We're buying cheap companies and they were using
debt to fund the purchases they got. When the investments
went well. They went well, really well, because they were levered,
(36:16):
And my logic is, why not just copy that strategy
but do it in public markets. So go and find
small cap companies all over the world that are trading
at prices that look like nineteen eighties or nineteen nineties
private equity, and that have similar capital structures. They're nicely levered,
and so you get that extra juice and the returns,
and so my ideas, let's profit from what private equity
used to do, which is sort of ironic even that
(36:37):
I'm such a critic of the industry, I'm not a
critic of what they used to do. I thought that
was brilliant, and I think that's what David Swinson fell
in love with, and I think a lot of other
people did. It's what they're doing now, which I think
actually bears very little resemblance what they were doing twenty
years ago. Funny how things can mutate under our noses
without us realizing that they've mutated, because we're still clinging
to a version of the past that doesn't exist anymore.
(36:58):
Financial markets, i think, are the place where that happens
most often, because we always invest in the thing that's
done well historically and by nature of people agreeing that
it's a good idea, it becomes a bad idea. We
are pack creatures and emotional creatures at the end of
the day, right, Thank you so much for being here
with me. This was really fun, my pleasure. I was
(37:28):
struck by how much my conversation with Danielle wasn't just
about the metrics and details of investing, and of course
there was plenty of that, but rather about human nature.
Why is it that we can know the present is
different from the past, yet cling to the past anyway.
Why is it that we become victims of our own success.
Why do we prefer narrative to numbers, or choose the
(37:51):
numbers that we want to support the narrative that's most convenient.
On a more practical level, I also came away from
this conversation quite concerned. One impetus for the devastating two
thousand and eight global financial crisis was something called the
shadow banking system, the buildup of debt in all these
places that regulators didn't see and couldn't control. I didn't
(38:13):
realize we were creating another shadow banking system with all
the debt from private equity deals. I have a hard
time believing this plays out well. Not for our markets,
but certainly not for the pension funds who are depending
on private equity to bail them out. Making a Killing
is a co production of Pushkin Industries and Chalk and Blade.
(38:35):
It's produced by Ruth Barnes and Rosie Stoffer. My executive
producers are Alison mcclein. No relation in Making Casey. The
executive producer at Pushkin is Mia Loebell. Engineering by Jason
Gambrell and Jason Rostkowski. Our music is by Jed Flood.
Special thanks to Jacob Weisberg at Pushkin and everyone on
(38:56):
the show. I'm Bethany McClain. Thank you so much for listening.
You can find me on Twitter at Bethany mac twelve
and let me know which episodes you've most enjoyed.
I'm Bethany McClain. This is making a killing in this show.
I cut through the hype and handwringing to reframe the
stories you thought you understood and uncover the ones you
didn't know were important. It isn't a secret that pension funds,
which many of us rely on to pay for our retirements,
(00:29):
are in dire straits ready for a scary number. The
combined funding deficit of public pension plans across all fifty
states was an alarming one point to eight trillion dollars
in twenty seventeen. Thank goodness, we have a savior. It's
the private equity business. The belief, simplified, is that private
equity will invest in private companies or buy public companies
(00:52):
and take them private. Those no doubt brilliant investments will
play out perfectly and help us achieve the returns we
need in our health and retirement benefits will be secured.
The chief investment officer of the California Public Employees Retirement System,
which is the biggest pension fund in the United States,
recently advocated putting more money in private equity. His quote,
(01:14):
we need more of it, and we need it now.
He was a risk officer at Lehman Brothers. But anyway,
he's far from alan what insiders called dry powder. The
amount of uncommitted capital that private equity firms can invest
now exceeds two trillion dollars. But what if it's not true?
What if private equity isn't going to make our retirement
plans fat and happy. This is a question with huge
(01:36):
ramifications for pension funds, for those who depend on them,
and for our markets. After all, some private equity deals
have gone wrong in very public ways. Look at Toys
are Us, which buyout firms Bane and KKR, along with
Fornato Realty Trust acquired for six point six billion dollars
in two thousand and five. When Toys are Us filed
(01:57):
for bankruptcy in two seventeen, the toy company said it
had five point three billion in debt and was paying
four hundred million a year in debt service payments. Over
thirty thousand employees were left without jobs. In late June,
San Jose Inside newspaper published a piece noting that San
Jose's two pension funds hit up the amount they were
(02:19):
putting in so called alternative investments from less than ten
percent to almost fifty percent over the decade spanning from
two thousand and six to two sixteen. Over that same period,
those two plans posted returns that were consistently lower than
ninety nine percent of their peers. So there are some skeptics.
(02:40):
Chief among them is Daniel Rasmussen, himself an investor, although
that's probably too simplistic an introduction. Another investor has likened
Rasmussen to the fighter pilot Maverick in the movie Top
Gun because. In a very controversial piece published in American
Affairs last summer, rasmusen dismantles what he says are the
three assumptions that underlie the boom in private equity. One
(03:02):
that private equity firms make money by improving the companies
they buy. Two that private equity is less volatile and
less risky than public markets, and three that private equity
will significantly outperform every other investment. Resmussen writes there is
near complete consensus on these three points among academics, investors,
(03:22):
and private equity firms, and he believes that the consensus
is dead wrong. I have to admit, whenever I hear
the phrase near complete consensus, I get nervous too. So
I'm thrilled to have Daniel here with me to discuss
the risks and realities of private equity. After working at
Bain Yes, a private equity firm, and Bridgewater, a hedge fund,
(03:42):
Dan founded his own firm called Verdad Advisors. Dan is
also the New York Times best selling author of American Uprising,
the untold story of America's largest slave revolt. So, Dan,
(04:09):
what do you think when you hear the phrase near
complete consensus? The most dangerous thing in financial markets is
consensus because consensus is what drives bubbles. And I think
what's really frightening about private equity today is that over
I think a recent Prequin service at over ninety four
percent of institutional investors believe that private equity will outperform
(04:31):
the public equity markets by greater than two percent per year.
And yet you cite in the piece you wrote this
Cambridge Associate study that showed that private equity returns have
actually lagged the Russell two thousand index by one percent
in the S and P five hundred by one point
five percent a year over the past five years. Why
is there this gap between perception and reality? Largely because
(04:52):
the returns prior to two thousand and six were so good. So,
before private equity became the hottest asset class, it was
a relatively niche alternative. It was largely pursued by some
of the smartest people in the business, pioneered by Yales
and Dowmen and others, and it worked really well for
about twenty years. And in the late mid to light
two thousands, people started to realize how well Yale and
(05:16):
others had been doing in the asset class, and they
started to pile in. So all the performance stats that
people look at include this wonderful pre two thousand and
sixth period. Even though the post two thousand and six
period has been mediocre, it hasn't yet been disastrous. And
so people combine the mediocre returns the great returns. They say, ah,
where also are we going to look for something that
(05:37):
is a good chance of beating public equities? So, in
a sense are they victims of their own success? Of course,
and this is a perpetual story in markets. Everything begins
as a good idea and then Wall Street packages it
up and sells it, and if it keeps working, it
gets to be a bigger sales pitch, and the more
money that flows in, the more efficient the market gets.
And if more money keeps pouring in and the opportunity
(05:58):
set is small, that's where you at really bad market conditions.
So we've talked a lot on my show about Wall
Street being such a short term machine, and I'm always
interested in the places that seem to get exemptions. And
so why is it that people are willing to give
private equity so much credit for past returns that are
so long in the past. One of the great allures
(06:20):
of private equity. One of its big attractions is the
way that the returns are accounted for. So, because private
equity is private, the returns are calculated by accountants that
are employed by the private equity firms, who issue statements
on a quarterly basis saying what each company in that
private equity fund is worth. And those are highly subjective marks,
(06:40):
and they tend to track the financial metrics of those
businesses much more than they track the market. So in
Q four, for example, markets were down fifteen twenty percent
Q four eighteen, private equity marked down their portfolios and
aggregates somewhere between zero and five percent. Right, wow, So
either of these private equity guys are super geniuses who
generated fifteen percent of alpha in a three month period,
(07:03):
or the way they're marking their assets isn't truly to market.
And I think the reality is that they're not marking
them to market. They're marking them to what they think
they're worth. And that might be a very thoughtful, elegant,
intellectually correct way of valuing them, but it's not. The
markets are not efficient in that way. They're much more
volatile than they should be. And so because these returns
are artificially smoothed, people have grown lulled into complacency. And
(07:26):
there's always the case that someone can say, well, yes,
I know it hasn't worked over the past three years,
but it's early in the funds ten year. This is
a ten year fund. It'll be marked up over time.
It always has been. And these are the dynamics that
allow people to get fooled and lulled into complacency and
not get any feedback about whether their investments are working
or not. I think you used a line in your
piece that I loved that the CIO of the Public
(07:49):
Employment Employee Retirement System of Vitaho called this the phony
happiness of private equity. It always makes me. Think of
my favorite line from the Sun also rises? Isn't it
pretty to think? So? That's exactly right, Much prettier to
think so than to admit that these returns may actually
not be all they're cracked up to be. You had
a great example in the piece you wrote of this too,
not just the fourth quarter of two thousand and eight,
(08:10):
but what happened when energy prices crashed in twenty fourteen
and twenty fifteen. Do you want to walk us through that? Yeah, So,
you know, oil prices dropped more than fifty percent, maybe
maybe even seventy percent or something like that, and private
equity energy private equity had been it, you know, investment class,
which it is again now now for reasons that you've
(08:31):
documented very well, don't make sense to me. But these
private equity firms had bought a lot of shale drilling firms.
They levered them up much more than other investments in
the industry. Public energy stocks were generally down about fifty percent,
and I think at the time I wrote this piece
in the middle of twenty sixteen, the private equity assets
(08:51):
were not marked down at all, So they were marked
at one right, so they even the twenty fourteen and
fifteen vintages were marked at one. So they deployed a
bunch of money and highly levered very small shell drillers.
And even though the public equival was down thought fifty,
oil prices were down sixty or seventy, right, they were
marking them at one. There was one energy pe executives
asked you, why is it that your portfolios marked at one?
(09:13):
He said, well, we're looking through the cycle when we
make our valuations once again. Isn't it pretty to think so? Right?
I saw a quote actually that some eighty two percent
of people in private equity use internal valuations rather than
any kind of external benchmark. Why do investors let our
investors just so desperate to believe that it's in this
(09:33):
lack of volatility that they allow private equity firms to
get away with it? Yeah, I mean, I think we're
living in an age where everyone thinks back to the
pain of O eight. I mean, I think it's very
much on people's minds private equity. I think the Russell
two thousand small cap index was down about sixty percent,
peeked a trough and eight private equity was marked down
about thirty percent. And so if you're sitting there on
(09:55):
the investment committee of one of these pension funds or
college endowments. You look back at that experience and you
love private equity because that's what allowed you to sleep
at night during that period, or to tell your committee
that you were beating the market or you weren't down
as much as the S and P. Right, you know,
our and dowment did fine through the crisis. And of
course it was a myth. But it's a myth that
(10:16):
everybody is happy to believe in. I mean, markets are
too volatile, right, I mean, nobody likes it when their
portfolios down fifteen percent in three months, and this offers
a pleasant alternative. Why do you think it continues with
all of the warning signs that are building up to
be so easy to sell private equity firms, institutional investors,
It serves a pleasant fiction that a lot of us
(10:38):
would like to believe in. It's like your quote from
aus Son also rises. I think we'd like to believe
that very smart, well educated Harvard Business School graduates can
run companies better than other people, and that if we
meet them and we really vet them, and then they
go and buy these companies and they don't just buy
a piece of them, right that they buy the whole company,
(10:59):
and they really sit on the board and they work
really hard at it, and they can improve the companies.
David Swinson, who's the Yale endowment manager. So this is
a superior form of capitalism. Yes, it's just better. It's managed.
It's managed by just the type of people you think
should be able to manage it very well. Okay, so
we've addressed your first myth that these funds are not
less volatile. It's just the accounting that actually helps them
(11:22):
look less volatile, the accounting we're all actually willing to
buy into. And now there's this myth. One of your
other myths is that they actually can improve companies. And
you've actually done a lot of work showing that that's
not true. It's not just a belief of yours. And
what's the most compelling thing you've found that made you
say this just isn't true. What do I want to
address this question? It's hard because private equity companies are private.
(11:44):
So what I looked at is every private equity deal
where the company has issued public debt. Okay, so when
you issue public debt, you have to report your financials
at the time of issuing the debt, right, which is
when the transaction occurs, So you have the pre transaction financials,
and then of course you have to report to the
market what your returns are afterwards because the data is public.
So I found about I think three hundred or so
(12:06):
deals over the past a decade which I'd issued public
dat so it's a pretty broad cross section. And then
what I wanted to look at is pre acquisition what
the financials were, and then post acquisition and see if,
of course operational change is happening, and if it's happening
at a magnitude which is driving this very superior performance
to the public equity market. I figured it should be obvious, right,
(12:28):
I mean, I shouldn't have to look too hard. So
first I looked at trends in revenue growth YEA, and
broadly what I found is that revenue growth slowed post acquisition.
That's actually stunning, but it's not stunning if you think
about it in a different way, which is that private
equity firms want to buy good companies, so of course
they're going to select for companies that have been performing well,
which are going to be firms higher revenue growth than average.
(12:49):
But if the world reverts to the mean and there's
no skill, then you'd expect to see above average growth
in the past and mean growth afterwards. That's what you see.
And then you look at margins. So okay, well, maybe
maybe the private equity guys aren't driving revenue. Maybe they're
brilliant cost cutters, maybe their efficiency geniuses. There's such a
thing as being a brilliant cost cutter. Maybe Okay, aggressive
(13:09):
cost cutter, savage cost cutter, a predatory costcutter. I get it.
But I saw basically no change in margins pre and
post acquisition. So it wasn't like revenue growth was expanding.
It wasn't like margins were expanding. So what did change, Well,
very systematically, in every deal observed, there was a massive
increase in debt. And with a massive increase in debt,
a massive increase in interest payments, and because of the
(13:32):
massive increase in interest payments, generally a contraction and investment spending.
So if you think about what is the operational playbook
from a data perspective, the operational playbook is to add
debt to companies. That's it. That's the leverage buyout it's
private equits just a story of debt. It's a story
of debt. Does this make private equity sort of a
parable for our times in the sense that this is
(13:54):
the era of debt? Yeah? And I think that post
oeight a sort of a set of interesting things happen, right.
I mean, one is that interest rates obviously dropped a lot.
Two is that the FED really intervened to abrogate the
default cycles. There are fewer defaults in O eight than
there were, for example, in OH three, So I think
a lot of people got lulled into complacencies. They say, Okay,
we can take risks with debt because interest rates were
(14:16):
low and the Fed's going to bail us out, so
why not go down the quality scale, take a little
bit more credit risk. Surely it couldn't go wrong. And
that's large to what we've seen in private equities. So,
you know, the debt levels have just risen and risen
and risen and risen. And because of regulation, the banks
are no longer the ones public banks are no longer
(14:38):
the ones providing the stat financing. Now it's in the
private lending market, the business development corporations, the mid market lenders,
the clos this whole heave of alternative lenders that are
the ones providing this debt. And these are firms with
very little track record. They're new firms, they don't have
a lot of experience, they haven't gone through cycles. They're
very aggressive, and they're willing to lend to all our
(15:00):
companies more money than banks ever would have lent. And
they're willing to do it. And this is sort of
a very common thing that goes on in the industry
on ProForma financials. So the FED, for example, put it
rule in saying banks shouldn't lend a company is more
than six times IBADA. So what happened in the wake
of the crisis is that a lot of these private
lenders and mid market lenders said, Okay, of course we're
(15:21):
not going to lend more than six times EBITDA. But you,
the private equity firm, tell us what IBADA is right,
Because EBA does a made up number. It's not a
it's not a net income, it's not cash from operations,
almost whatever you want it to be, not quite exactly.
So it's called ProForma ibnore all the bad stuff, earnings
before all the bad stuff, and Moody has just done
(15:42):
a study on this found that proformat ibada was generally
about thirty percent higher than gap ibada, never lower. So
I want to come back to this because this seems
to hint to me at kind of round two of
the shadow banking system that played such a dangerous role
in the financial crisis of two thousand and eight. But
you you said something when you were mentioning the lack
(16:03):
of operational improvement to private equity firms that I found fascinating,
which you said that there it's actually less investment, that
they cut back on investment. And I find that really
interesting because part of the marketing of private equity is
that it's an escape from the short termism of the
market that by allowing companies to be in private hands
and to not have to meet quarterly earnings expectations, you
can invest more and you can allow companies to take
(16:26):
the big bets on businesses that we all want to
see them make. Your data would seem to suggest that's
not true. Lookt decreases your flexibility, right If you o
lenders a huge amount of money, right, you don't have
the flexibility to take some big, large scale bet And
these firms are not taking out debt to fund building
of a new factory. They're taking out debt to fund
(16:46):
the acquisition of themselves. So I think that just simple
logic would suggest that the firms that are going to
invest a lot are not the most levered firms. How
do you think about the returns garnered from the big
dividend payments that it be comes such a feature of
private equity because I might be wrong, but that strikes
me as new. So back in the battle days of
(17:06):
financial engineering, right, private equity firms didn't routinely do that.
They didn't add on debt and pay themselves a big
dividend and get their money out the way that happens
in so many transactions today. Am I right about that?
And is that a relatively new feature that is, yes,
contributing to what returns there are, but also potentially quite
problematic both for future returns and for the state of
(17:28):
these companies. Yeah. So this is going to come back
to the lessons learned from O eight, And one of
the lessons learned from O eight by the private equity
funds was that they bought a lot of things in
a six or seven and then they couldn't get any
money out of them until twenty ten or twenty eleven, right,
so they were had this long period where they'd put
cash in and they didn't get cash out, and that hurts.
The key performance metric for private equity is called the
(17:50):
internal rate of return right and time based, and it's
time based, so you have to have a short window
between when you put capital to work when you return it.
And so all the IRR on the oh six and
oh seven vintage funds were really low, and so a
lot of firms convince convence study groups to say, okay, well,
what are we going to do to make sure our
RR numbers are attractive. And one of the things that
(18:12):
they came away with is that you need to return
capital early on in the investment. So you need to
shorten the time between when you deploy capital when you
give it back. So there are two ways to do that.
One is you take out a subscription line of credit,
so you buy a company, so you close in March,
you borrow all the money you need for the closing,
and then you wait until December to call the capital
(18:32):
from your investors. So you've shortened the investment period by
about nine months maybe, So that's a subscription line of
credit that you do on the front end with yet
more debt, with more debt, right, but it's short term debt,
so it's pretty low rate, but it really helps the RR.
And then the second thing is after about a year,
if the operational metrics are good, and usually if there's
anything you can generally forecast better, it's very short term
(18:53):
results right after you buy something. So you buy it,
maybe you make the quick fixes, ebit does up a
little bit, You go back to the bank, you say, look,
EVA does up five percent or timbercent. We can take
out tim percent more debt, and we're going to do that.
We're gonna refly at we're going to pair ourselves at
dividend and then they get cash back really fast. So
now their rrs looking great. And this has been it
can't be understood how important that those dividend payments are
(19:15):
to improving rrs. And that's really been one of the
big drivers behind this. But that's actually frightening because it
would suggest that the returns is meager as they have been,
are also being juiced by tactics that may not be
that are not sustainable. That's right, and hold periods. Actually
this is interesting. So the underage Slifer, who is the
most cited financial economist I think ever, and he says,
(19:38):
there are three ingredients to a financial crisis. It's consensus, leverage,
and illiquidity, and those are the dangerous trio. And obviously,
you know we have consensus here, we have increasing leverage,
and what's really scary is the illiquidity aspect of this.
So one of the ways the private equity firms, you
can think about measuring private equities, how long is the
(19:58):
average hold period? So they buy company and then they
sell it, and I think in O five and oh
six is average hold here is about three or four years, right,
So they buy it, sell it in three or four years.
Now the genius to fix it in the music, right,
they could do it that quickly. Now it's six or
seven years. Okay, So these investments have gotten a lot
more a liquid So that's another reason they're taking the
(20:19):
dividends out and they're actually holding them longer. So why
are they holding them longer? I would argue they're holding
the longer because they can't sell them. They can't sell
them at a higher peru, right, Hence the illiquidity right.
Another interpretation, which they would say, is we're holding them
longer because it just we're having such a wonderful operational
impact that we realize that just within another two years,
(20:40):
under our benevolent management, we could really turn the corner operationally.
So you can choose which your explanation. But I'm a cynic.
What can I say? Hey, one of the things I
find fascinating about you is that you're not criticizing from
the outside. How did working at Bain helps shape your views?
And did you know when you went into Bain that
you might become optic about private equity or did you
(21:01):
go into it thinking this is the greatest thing ever.
I'm going to be an operational genius who's going to
help transform corporate America. Yeah. I did think of myself
as a genius who is going to transform over to
America's I think many twenty one year olds do. And
I think that initially what attracted me to private equity
was I think the same thing that attracts a lot
of investors to it. I thought, Okay, here's a chance
to not only have the intellectual side of making investment decisions,
(21:25):
figuring out what a good company is, or what a
good industry is. But there's also this management. You know,
you actually own the company, so you can make a
difference and you can improve it. And wouldn't it be
great if you could make money by doing both at
the same time. And she look at the returns and
everyone smart thinks this is a good idea. Right, Go
talk to any college endowment. What do they do? They
think it's the best thing ever. And I was very
(21:47):
persuaded by that. And I think that when I started
doing more and more work, what I uncovered was not
that anyone's intentions were bad. I think generally these are
very smart, very well intentioned, good people, but that the
prices for assets in the private market, we're going up
and up and up. And because the private equity models
(22:07):
to lever everything at sixty five percent, if you go
from paying seven times cash flow to ten times cash flow,
that means you're going from putting four times cash flow
of debt to six times cash flow of debt. Well,
and then you go to twelve times fourteen times. You know,
the higher you go, the more debt you're putting on it.
And when I started to realize, we looked at a
huge data set of historic private equity deals. Was that
(22:29):
those expensive deals, because of the large amounts of debt,
had unusually high default rates and we're on unusually bad investments.
That most of the money was made buying the cheaper
investments right where you're putting a reasonable amount of debt on,
which seems logical to me. And this is also why
people criticize financial engineering, because back in the eighties and nineties,
financial engineering ment buying things really cheap and funding the
(22:51):
purchase with debt, which I actually think is a great
way to make money, right, you buy cheap things with
debt makes a lot of sense. Expensive things with debt, right,
like whether that's a yacht or a company or a diamond.
You know, you know it's not going to work out
so well. And that's was very observable in the data.
And when I started to see that data, I said, well,
this doesn't really make sense to me. And that was
(23:12):
in twenty eleven, twenty twelve. That was the moment of
your conversion from the lever to skeptic. Well, and then
since then purchase prices have gone up another twenty percent,
So you know, I was skeptic probably too early, right,
But things have only gotten crazier and debt levels only
gotten crazier. Why is it that, given that data doesn't
usually lie well, I guess depends on how you interpret it.
(23:32):
But the data seems so straightforward and so obvious in
the logic seems so obvious. Buy something cheap, it's a
lot easier to make money than if you buy something
that's really expensive. Why won't the industry see it? I
actually loved this statement that Bain made about your criticism
of the industry. Mister Asmussen was a junior member of
our team during his employment without full insight into our
investment process or operational value. Add Yes, I hope to
(23:57):
meet someone with full insight someday, but I have with
operational value speaking, I have cynicism value. Add perhaps that
I think I think that's a better thing. But I
think that there are a few things have gone on. Right.
One is this lack of defaults. So's there have been
an unusually low rate of defaults over the past decade. Right, So,
(24:17):
bad lending behavior has not been punished. Okay, buying really
junky private credit assets has done. Okay, it's done. Okay,
it hasn't defaulted. And because so much more of it
is in private hands. The private people don't have as
much of an incentive to push stuff into bankruptcy. It's
not as visible when credit and stats are deteriorating. There's
(24:37):
this extend and pertend philosophy. So because of that, the
bad things in private equity portfolios have not gone belly up. Now.
There have been a few public exceptions, right, which we
can talk about, ye, a few of the big public exceptions,
but a lot of them have become sort of what
I would call zombies. Right. These are the firms that
are dragging the whole periods longer and longer. Right, So
(24:58):
they don't default, they don't go bankrup they just stay
in the portfolio. Right. I even heard one large private
equity manager come out and say, the thing I'm most
proud of about my firm is that we've never lost
money on an investment. Right. Amazing. And I said, well,
what percent of the companies that you've ever bought do
you currently own? And he said about sixty five percent.
I don't believe you've never acknowledged that you've lost money
(25:19):
on investment, right, Right, But private markets allow you to
do this, right, so you can hold on longer than
the equivalent public asset, you don't have to pay the piper,
and in time of low defaults, you really don't have
to pay the piper. And then if you look at
what's happened in the public markets, that there's been a
huge premium for growth, right, So anything with high revenue growth,
high sales growth has done really well and has been
(25:39):
valued it really insanely high prices. So you've had a
corner of the portfolio, which is the very expensive but
very high growth things that actually have been great investments. Right,
You've been able to buy them at a really high
price to flip them in your sale for a period
of time, and so you've got this contradictory lesson. Right
on the one hand, you're saying, look all the stuff
I paid crazy prices for I sold two years later
(26:01):
for an even crazier price, and look how much money
I made. And then yeah, I paid some high prices
for some other stuff. But you know it's still marked
at one and you know, our operational guys tell me
that next year it's going to turn the corner and
put up that up for market. Who knows what it's
going to be worth. So it's a bit of a
version of check prints the former CEO of City Group
who said famously, right before the financial crisis broke wide open,
(26:22):
as long as the music's playing, you have to keep dancing. Yes,
what's scary is to see these metrics, whether that's fundraising metrics,
So more money being raised, more dry powder, which leads
to higher purchase prices, which means to higher debt levels,
which means to lower credit quality of either debt that's issued,
which leads to longer hold periods. Right, every single one
(26:42):
of these metrics is deteriorating. There's not one that's not
getting worse. But it's all driven by fundraising. So despite this, right,
the fundraising is going in exactly the wrong direction. It
is actually causing a lot of this bad behavior. Because
I think people often talk about they say, well, look
there are five hundred companies in the five but there
are thirty thousand or one hundred thousand small companies in
(27:02):
the US. They're ripe for private equities, so it's a
much better market. But what they don't realize is that
it's a power law distribution, just like income. Right, Like
Amazon is worth ten thousand small companies, right, So the
actual market is much much bigger for these big liquid
companies and small companies, and yet the amount of capital
that's now chasing these tiny little companies is really overwhelming
that market. And I think you've quoted or at least
(27:24):
you've heard some private equity officials themselves expressing concerns about this,
worries about the sheer amount of money that needs to
be invested, but yet they don't stop. Yeah, well yeah,
I mean it is funny. I had at one point
I should find a series of quotes from KKR, Apollo,
Carlyle Blackstone, the heads of all these firms, saying this
(27:45):
is the hardest time it's ever been to invest. Our
Number one problem is high purchase prices. What's going on
in the debt markets isn't sane. I mean, they're very
open about it, they see it, and yet they're raising
bigger and bigger funds. And as some component of that,
not just their own belief in their own brilliance, but
also the fact that they're paid a management fee upon
those assets. So there's an incentive for asset gathering as
(28:09):
opposed to I mean, at what point, even with a
giant firm, does the incentive for asset gathering become become
more compelling than the incentive to to make good investments.
I don't even think it's it's them driving it. I
mean they're the beneficiaries of a massive wave. They couldn't
stop raising money if they tried. I mean I talked
to so many pension fund managers and endowment manages and
(28:31):
I say the same things. I said, Yes, why are
you doing this? You know, why don't you just press
pause for a little bit. And one of the things
I say was, well, she if we don't commit to
fund six, we're never going to be let into fund seven. Right,
So there's this It's not only fear of missing out,
it's fear of being locked out because right, because you
didn't stick with them for every single fund and so
(28:54):
and then they say, well, and markets have been going amps.
If we want to maintain a steady allocation to private
equity and this public markets went up twenty percent, we
need to increase our allocation private equity by twenty percent
versus what we committed to the last fund. Right. So
they're going to their managers and they're saying, we need
I know, you took one hundred million last time, it
can you take two hundred million this cycle, and which
private equity guy is going to say, well, no, we
(29:15):
you know, it's really not a good time in the cycle. Right,
They're going to say, oh, right, you want me to
manage four billion and so of two billions, so you're
a double my salary. You're almost making less. Say no,
you're almost making me feel bad. For these poor private
equity guys with all of these billions of dollars being
thrown at them, I mean, they're just helpless in the
face of it. Who could resist. One of the criticisms
I've heard of your work or your theory comes down
(29:37):
to this, which is that private equity may be dangerous,
but public markets are way more dangerous. How would you
respond to that? Yeah, I think public markets are more volatile, right,
so they feel more dangerous right where they or they look,
the volatility is more obvious or more real and right,
and that also enables bad behavior. Right, that's very easy
to sell at the bottom and buy at the top
and right, whereas private equit at least you're locking up
(29:58):
your capital into something for a long period of time
and you literally can't sell it. So maybe that's a
good thing. But I think when I think about risk,
I think about two primary forms of risk. One is
valuation risk, so are you just paying too much given
what an asset has been worth historically or relative to
other assets? And then I think second is credit risk,
so is what you're buying going to go bankrupt? Right?
(30:21):
So two very simple ways of thinking about it. So
for public markets, right, you could say, is their valuation risk? Yes?
In the US, yes, stocks are priced expensively relative to
long history, but probably not so much bankruptcy risk, but
not bankruptcy risks there's not a lot of debt. Right,
Is Apple or Amazon or Facebook going to go bankrupt? No? Right,
(30:41):
they don't have a lot of debt. They're not going
to go bankrupt. What's different with private companies? Right? Private
companies are a lot smaller. So the average private company
is actually about one tenth the size in terms of
market cap as the average Russell two thousand small cap companies.
So these are tiny, tiny little companies, and they're tiny
little companies that have probably about three to six times
(31:02):
as much debt on them as the average public company,
which is ten times bigger. Right, Right, So you're looking
at these tiny, tiny companies that are much much more levered,
and they're trading at prices that are twenty percent higher
than oh seven, I don't know. Both those things line
up for me, and I say, look, is it historically
risky as measured by historical volatility? No? Is it risky
(31:25):
as measured by the performance historically No? Both those things
suggest it's the best thing since slice bread. You shoul
put one hundred percent of your money in next it's
perfectly it's less volatile than bonds and as higher turns
than equities. But any prospective analysis that looks at okay,
but what are they actually buying? Right? That's what's scary, right.
And it's so interesting because going back to your point
about statistics, even if statistics often do tell the right story,
(31:48):
you have to be very careful about what statistics you
choose to look at, because the narrative you want to
hear can influence the statistics you choose to see. Right,
how dangerous is this is? I listen to that, I think, Okay, well,
the debt figures are really really frightening. At the same time,
if these are really really small companies, how much damage
does this do? If you're right in the bankruptcy risk
(32:08):
is big? How much damage does this do to the
financial system? The interesting thing about it, and part of
this was created by the FED saying, hey, this shouldn't
be done at banks, right, this should be done by
these private lenders and BDC. Did the FED actually say
that or did they just say this shouldn't be done
at banks without meaning right, right? Right? Right? Instead? Uh?
(32:35):
And so I think the impact on the economy, right,
So I think on the one hand, i'd say, look,
it's small, right, It really is a small It's a
drop in the bucket. But ben Burnank wrote his PhD
thesis on the small shocks big crises puzzle, right, So
small shocks calls big crises with some level of regular
some extent, right, And so I would say, look, is
(32:56):
it a tiny thing. We're alter the size of the economy. Yes?
Could it have an out sized impact if it impacts
how market participants act? Yes, Now where will the pain
be felt the most? I would say, I don't know
if it'll affect the economy. I don't know if it'll
affect the broader market, right, I do know it'll affect
people that own it, Okay, And who owns it? Pension funds,
pension funds and college endowments, some of whom are putting
(33:18):
thirty forty at the upper end percent of their money
into private markets, private equity, private debt, venture capital. Right,
I mean because of this institutional consensus, right, And I
think those are the people that are going to get
whacked by this, people who can least afford it, at
least in the case of pension funds. So it's right, right.
Do you think anybody understands given that the financing side
(33:40):
of this, the debt provision side of this, has become
so opaque, do you think there's anybody who understands what
goes on there? Is it possible to figure that out?
I think there certainly are the problems. There's no way
to short it, right, it's all private, yea. How do
you short science private? You can't, So there's no you know,
there's no gym. We don't have a big short yet. Right,
You can't really short it. All you can do is say, gee,
(34:04):
you know, I think you're a little crazy to be
putting money there, and then the person goes back to
and so public markets are down twenty last year and
our private equity port flows down five So you're the
crazy one, right, right. Is there any irony in the
fact that the very private equity firms that talk up
the benefits of private investing Blackstone, KKR, Apollo are themselves
publicly traded. It is remarkable, isn't it. I'm not sure
(34:27):
you'd think they could go private and then improve themselves.
Maybe that's what we'll recommend that. Maybe that's what we'll
get to actually, as when the private equity firms start
taking each other private in order to operationally improve themselves,
and then all the workers there, all the brilliant Harvard MBAs,
can figure out what it feels like to be a
line on right, and I'll reveal to them that their
models aren't very accurate, so they probably could use about
fifty percent fewer analysts exactly. Now, that would be a
(34:50):
perfect fictional ending about all this. So if you had
to predict this, does this end in a bloodbath? Are
just in disappointment and slow, sad disappointment for the pension funds,
as we've discussed, who need these returns the most. I
think it really depends on whether we have a default
cycle or not. So if we have a real default cycle,
like we had No Three, then this thing blows up right,
(35:11):
because all these things are not credit worthy. I mean,
and so if there's any change in credit standards from
extremely loose to somewhat reasonable, a huge percentage of this stuff,
you know, I'd say upwards of thirty percent of private
equity deals, and my guess would be going to default.
This stuff is really bad paper. However, standing number, I
(35:31):
think zombification is a real alternative, right, which is that
we just extend and pretend, right, so it just fizzles
and all of a sudden, you've got a fifteen year
old private equity fund that still has three investments that
are still marked at one that just hasn't sold, and
you're disappointed, but the rr still looks good because some
of the dividend recaps early on, right, I mean, I
think that's a really good and frightening phrase. Just tell
(35:55):
us quickly what you're trying to do with for dad.
My premise is that if you look at the early
years of private equity, the returns really were wonderful during
the financial engineering years, and there the two key ingredients
to that. We're buying cheap companies and they were using
debt to fund the purchases they got. When the investments
went well. They went well, really well, because they were levered,
(36:16):
And my logic is, why not just copy that strategy
but do it in public markets. So go and find
small cap companies all over the world that are trading
at prices that look like nineteen eighties or nineteen nineties
private equity, and that have similar capital structures. They're nicely levered,
and so you get that extra juice and the returns,
and so my ideas, let's profit from what private equity
used to do, which is sort of ironic even that
(36:37):
I'm such a critic of the industry, I'm not a
critic of what they used to do. I thought that
was brilliant, and I think that's what David Swinson fell
in love with, and I think a lot of other
people did. It's what they're doing now, which I think
actually bears very little resemblance what they were doing twenty
years ago. Funny how things can mutate under our noses
without us realizing that they've mutated, because we're still clinging
to a version of the past that doesn't exist anymore.
(36:58):
Financial markets, i think, are the place where that happens
most often, because we always invest in the thing that's
done well historically and by nature of people agreeing that
it's a good idea, it becomes a bad idea. We
are pack creatures and emotional creatures at the end of
the day, right, Thank you so much for being here
with me. This was really fun, my pleasure. I was
(37:28):
struck by how much my conversation with Danielle wasn't just
about the metrics and details of investing, and of course
there was plenty of that, but rather about human nature.
Why is it that we can know the present is
different from the past, yet cling to the past anyway.
Why is it that we become victims of our own success.
Why do we prefer narrative to numbers, or choose the
(37:51):
numbers that we want to support the narrative that's most convenient.
On a more practical level, I also came away from
this conversation quite concerned. One impetus for the devastating two
thousand and eight global financial crisis was something called the
shadow banking system, the buildup of debt in all these
places that regulators didn't see and couldn't control. I didn't
(38:13):
realize we were creating another shadow banking system with all
the debt from private equity deals. I have a hard
time believing this plays out well. Not for our markets,
but certainly not for the pension funds who are depending
on private equity to bail them out. Making a Killing
is a co production of Pushkin Industries and Chalk and Blade.
(38:35):
It's produced by Ruth Barnes and Rosie Stoffer. My executive
producers are Alison mcclein. No relation in Making Casey. The
executive producer at Pushkin is Mia Loebell. Engineering by Jason
Gambrell and Jason Rostkowski. Our music is by Jed Flood.
Special thanks to Jacob Weisberg at Pushkin and everyone on
(38:56):
the show. I'm Bethany McClain. Thank you so much for listening.
You can find me on Twitter at Bethany mac twelve
and let me know which episodes you've most enjoyed.
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