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