WEBVTT - The Risks and Realities of Private Equity, with Dan Rasmussen 0:00:08.800 --> 0:00:14.120 I'm Bethany McClain. This is making a killing in this show. 0:00:14.240 --> 0:00:16.919 I cut through the hype and handwringing to reframe the 0:00:16.960 --> 0:00:20.239 stories you thought you understood and uncover the ones you 0:00:20.320 --> 0:00:26.239 didn't know were important. It isn't a secret that pension funds, 0:00:26.400 --> 0:00:29.080 which many of us rely on to pay for our retirements, 0:00:29.120 --> 0:00:32.479 are in dire straits ready for a scary number. The 0:00:32.560 --> 0:00:36.160 combined funding deficit of public pension plans across all fifty 0:00:36.240 --> 0:00:39.839 states was an alarming one point to eight trillion dollars 0:00:39.840 --> 0:00:44.280 in twenty seventeen. Thank goodness, we have a savior. It's 0:00:44.320 --> 0:00:48.839 the private equity business. The belief, simplified, is that private 0:00:48.840 --> 0:00:52.320 equity will invest in private companies or buy public companies 0:00:52.320 --> 0:00:55.880 and take them private. Those no doubt brilliant investments will 0:00:55.920 --> 0:00:59.160 play out perfectly and help us achieve the returns we 0:00:59.200 --> 0:01:02.120 need in our health and retirement benefits will be secured. 0:01:02.720 --> 0:01:06.960 The chief investment officer of the California Public Employees Retirement System, 0:01:07.200 --> 0:01:09.640 which is the biggest pension fund in the United States, 0:01:10.040 --> 0:01:13.880 recently advocated putting more money in private equity. His quote, 0:01:14.120 --> 0:01:15.959 we need more of it, and we need it now. 0:01:16.440 --> 0:01:19.160 He was a risk officer at Lehman Brothers. But anyway, 0:01:19.560 --> 0:01:22.880 he's far from alan what insiders called dry powder. The 0:01:22.959 --> 0:01:26.160 amount of uncommitted capital that private equity firms can invest 0:01:26.600 --> 0:01:30.759 now exceeds two trillion dollars. But what if it's not true? 0:01:31.200 --> 0:01:33.759 What if private equity isn't going to make our retirement 0:01:33.800 --> 0:01:36.840 plans fat and happy. This is a question with huge 0:01:36.959 --> 0:01:40.640 ramifications for pension funds, for those who depend on them, 0:01:40.800 --> 0:01:44.479 and for our markets. After all, some private equity deals 0:01:44.520 --> 0:01:47.760 have gone wrong in very public ways. Look at Toys 0:01:47.760 --> 0:01:50.600 are Us, which buyout firms Bane and KKR, along with 0:01:50.640 --> 0:01:54.360 Fornato Realty Trust acquired for six point six billion dollars 0:01:54.400 --> 0:01:56.960 in two thousand and five. When Toys are Us filed 0:01:57.000 --> 0:02:00.360 for bankruptcy in two seventeen, the toy company said it 0:02:00.440 --> 0:02:03.360 had five point three billion in debt and was paying 0:02:03.400 --> 0:02:06.800 four hundred million a year in debt service payments. Over 0:02:06.880 --> 0:02:11.320 thirty thousand employees were left without jobs. In late June, 0:02:11.400 --> 0:02:15.720 San Jose Inside newspaper published a piece noting that San 0:02:15.800 --> 0:02:19.000 Jose's two pension funds hit up the amount they were 0:02:19.040 --> 0:02:22.480 putting in so called alternative investments from less than ten 0:02:22.520 --> 0:02:26.240 percent to almost fifty percent over the decade spanning from 0:02:26.280 --> 0:02:30.600 two thousand and six to two sixteen. Over that same period, 0:02:31.000 --> 0:02:35.119 those two plans posted returns that were consistently lower than 0:02:35.280 --> 0:02:40.160 ninety nine percent of their peers. So there are some skeptics. 0:02:40.680 --> 0:02:44.040 Chief among them is Daniel Rasmussen, himself an investor, although 0:02:44.080 --> 0:02:48.000 that's probably too simplistic an introduction. Another investor has likened 0:02:48.120 --> 0:02:50.800 Rasmussen to the fighter pilot Maverick in the movie Top 0:02:50.840 --> 0:02:54.200 Gun because. In a very controversial piece published in American 0:02:54.240 --> 0:02:57.800 Affairs last summer, rasmusen dismantles what he says are the 0:02:57.840 --> 0:03:01.720 three assumptions that underlie the boom in private equity. One 0:03:02.040 --> 0:03:05.079 that private equity firms make money by improving the companies 0:03:05.120 --> 0:03:08.640 they buy. Two that private equity is less volatile and 0:03:08.760 --> 0:03:12.400 less risky than public markets, and three that private equity 0:03:12.400 --> 0:03:17.679 will significantly outperform every other investment. Resmussen writes there is 0:03:17.800 --> 0:03:22.119 near complete consensus on these three points among academics, investors, 0:03:22.120 --> 0:03:25.679 and private equity firms, and he believes that the consensus 0:03:25.919 --> 0:03:28.680 is dead wrong. I have to admit, whenever I hear 0:03:28.720 --> 0:03:32.600 the phrase near complete consensus, I get nervous too. So 0:03:32.639 --> 0:03:34.880 I'm thrilled to have Daniel here with me to discuss 0:03:34.920 --> 0:03:38.360 the risks and realities of private equity. After working at 0:03:38.400 --> 0:03:42.280 Bain Yes, a private equity firm, and Bridgewater, a hedge fund, 0:03:42.560 --> 0:03:46.360 Dan founded his own firm called Verdad Advisors. Dan is 0:03:46.400 --> 0:03:49.720 also the New York Times best selling author of American Uprising, 0:03:49.960 --> 0:04:09.720 the untold story of America's largest slave revolt. So, Dan, 0:04:09.960 --> 0:04:12.280 what do you think when you hear the phrase near 0:04:12.360 --> 0:04:16.159 complete consensus? The most dangerous thing in financial markets is 0:04:16.200 --> 0:04:20.359 consensus because consensus is what drives bubbles. And I think 0:04:20.720 --> 0:04:24.880 what's really frightening about private equity today is that over 0:04:25.120 --> 0:04:27.880 I think a recent Prequin service at over ninety four 0:04:27.960 --> 0:04:31.400 percent of institutional investors believe that private equity will outperform 0:04:31.440 --> 0:04:33.880 the public equity markets by greater than two percent per year. 0:04:34.120 --> 0:04:36.760 And yet you cite in the piece you wrote this 0:04:36.839 --> 0:04:40.039 Cambridge Associate study that showed that private equity returns have 0:04:40.120 --> 0:04:44.080 actually lagged the Russell two thousand index by one percent 0:04:44.160 --> 0:04:46.080 in the S and P five hundred by one point 0:04:46.120 --> 0:04:49.120 five percent a year over the past five years. Why 0:04:49.160 --> 0:04:52.640 is there this gap between perception and reality? Largely because 0:04:52.640 --> 0:04:56.200 the returns prior to two thousand and six were so good. So, 0:04:56.240 --> 0:04:59.640 before private equity became the hottest asset class, it was 0:04:59.680 --> 0:05:03.599 a relatively niche alternative. It was largely pursued by some 0:05:03.640 --> 0:05:06.200 of the smartest people in the business, pioneered by Yales 0:05:06.240 --> 0:05:09.440 and Dowmen and others, and it worked really well for 0:05:09.560 --> 0:05:12.240 about twenty years. And in the late mid to light 0:05:12.320 --> 0:05:16.440 two thousands, people started to realize how well Yale and 0:05:16.480 --> 0:05:18.520 others had been doing in the asset class, and they 0:05:18.520 --> 0:05:21.719 started to pile in. So all the performance stats that 0:05:21.800 --> 0:05:24.400 people look at include this wonderful pre two thousand and 0:05:24.400 --> 0:05:27.159 sixth period. Even though the post two thousand and six 0:05:27.200 --> 0:05:31.600 period has been mediocre, it hasn't yet been disastrous. And 0:05:31.680 --> 0:05:35.680 so people combine the mediocre returns the great returns. They say, ah, 0:05:35.720 --> 0:05:37.200 where also are we going to look for something that 0:05:37.320 --> 0:05:39.719 is a good chance of beating public equities? So, in 0:05:39.760 --> 0:05:42.479 a sense are they victims of their own success? Of course, 0:05:42.480 --> 0:05:45.960 and this is a perpetual story in markets. Everything begins 0:05:46.000 --> 0:05:48.960 as a good idea and then Wall Street packages it 0:05:49.040 --> 0:05:51.640 up and sells it, and if it keeps working, it 0:05:51.720 --> 0:05:53.680 gets to be a bigger sales pitch, and the more 0:05:53.720 --> 0:05:56.440 money that flows in, the more efficient the market gets. 0:05:56.480 --> 0:05:58.640 And if more money keeps pouring in and the opportunity 0:05:58.680 --> 0:06:01.640 set is small, that's where you at really bad market conditions. 0:06:02.160 --> 0:06:05.280 So we've talked a lot on my show about Wall 0:06:05.320 --> 0:06:08.160 Street being such a short term machine, and I'm always 0:06:08.200 --> 0:06:11.280 interested in the places that seem to get exemptions. And 0:06:11.360 --> 0:06:13.560 so why is it that people are willing to give 0:06:13.600 --> 0:06:17.480 private equity so much credit for past returns that are 0:06:17.520 --> 0:06:20.440 so long in the past. One of the great allures 0:06:20.480 --> 0:06:23.520 of private equity. One of its big attractions is the 0:06:23.560 --> 0:06:27.360 way that the returns are accounted for. So, because private 0:06:27.360 --> 0:06:31.520 equity is private, the returns are calculated by accountants that 0:06:31.560 --> 0:06:34.160 are employed by the private equity firms, who issue statements 0:06:34.160 --> 0:06:36.880 on a quarterly basis saying what each company in that 0:06:36.960 --> 0:06:40.680 private equity fund is worth. And those are highly subjective marks, 0:06:40.839 --> 0:06:43.440 and they tend to track the financial metrics of those 0:06:43.480 --> 0:06:45.800 businesses much more than they track the market. So in 0:06:45.880 --> 0:06:50.040 Q four, for example, markets were down fifteen twenty percent 0:06:50.480 --> 0:06:53.560 Q four eighteen, private equity marked down their portfolios and 0:06:53.600 --> 0:06:56.640 aggregates somewhere between zero and five percent. Right, wow, So 0:06:56.960 --> 0:07:00.240 either of these private equity guys are super geniuses who 0:07:00.560 --> 0:07:03.240 generated fifteen percent of alpha in a three month period, 0:07:03.720 --> 0:07:06.719 or the way they're marking their assets isn't truly to market. 0:07:07.040 --> 0:07:08.960 And I think the reality is that they're not marking 0:07:09.000 --> 0:07:10.600 them to market. They're marking them to what they think 0:07:10.600 --> 0:07:13.120 they're worth. And that might be a very thoughtful, elegant, 0:07:13.120 --> 0:07:15.920 intellectually correct way of valuing them, but it's not. The 0:07:16.000 --> 0:07:18.600 markets are not efficient in that way. They're much more 0:07:18.680 --> 0:07:21.560 volatile than they should be. And so because these returns 0:07:21.600 --> 0:07:26.720 are artificially smoothed, people have grown lulled into complacency. And 0:07:26.800 --> 0:07:29.680 there's always the case that someone can say, well, yes, 0:07:29.760 --> 0:07:31.720 I know it hasn't worked over the past three years, 0:07:31.720 --> 0:07:33.520 but it's early in the funds ten year. This is 0:07:33.560 --> 0:07:36.160 a ten year fund. It'll be marked up over time. 0:07:36.200 --> 0:07:38.520 It always has been. And these are the dynamics that 0:07:38.560 --> 0:07:41.560 allow people to get fooled and lulled into complacency and 0:07:41.680 --> 0:07:44.200 not get any feedback about whether their investments are working 0:07:44.280 --> 0:07:46.480 or not. I think you used a line in your 0:07:46.520 --> 0:07:49.000 piece that I loved that the CIO of the Public 0:07:49.040 --> 0:07:52.320 Employment Employee Retirement System of Vitaho called this the phony 0:07:52.360 --> 0:07:55.120 happiness of private equity. It always makes me. Think of 0:07:55.120 --> 0:07:57.440 my favorite line from the Sun also rises? Isn't it 0:07:57.440 --> 0:08:01.600 pretty to think? So? That's exactly right, Much prettier to 0:08:01.680 --> 0:08:04.200 think so than to admit that these returns may actually 0:08:04.200 --> 0:08:05.720 not be all they're cracked up to be. You had 0:08:05.760 --> 0:08:08.080 a great example in the piece you wrote of this too, 0:08:08.200 --> 0:08:10.040 not just the fourth quarter of two thousand and eight, 0:08:10.080 --> 0:08:13.320 but what happened when energy prices crashed in twenty fourteen 0:08:13.320 --> 0:08:16.280 and twenty fifteen. Do you want to walk us through that? Yeah, So, 0:08:16.360 --> 0:08:19.400 you know, oil prices dropped more than fifty percent, maybe 0:08:19.520 --> 0:08:22.480 maybe even seventy percent or something like that, and private 0:08:22.520 --> 0:08:26.760 equity energy private equity had been it, you know, investment class, 0:08:26.920 --> 0:08:31.120 which it is again now now for reasons that you've 0:08:31.160 --> 0:08:34.600 documented very well, don't make sense to me. But these 0:08:34.600 --> 0:08:37.319 private equity firms had bought a lot of shale drilling firms. 0:08:37.640 --> 0:08:41.040 They levered them up much more than other investments in 0:08:41.080 --> 0:08:45.520 the industry. Public energy stocks were generally down about fifty percent, 0:08:46.040 --> 0:08:48.360 and I think at the time I wrote this piece 0:08:48.360 --> 0:08:51.240 in the middle of twenty sixteen, the private equity assets 0:08:51.280 --> 0:08:53.240 were not marked down at all, So they were marked 0:08:53.240 --> 0:08:56.080 at one right, so they even the twenty fourteen and 0:08:56.080 --> 0:08:58.800 fifteen vintages were marked at one. So they deployed a 0:08:58.840 --> 0:09:01.840 bunch of money and highly levered very small shell drillers. 0:09:02.120 --> 0:09:04.360 And even though the public equival was down thought fifty, 0:09:04.600 --> 0:09:07.280 oil prices were down sixty or seventy, right, they were 0:09:07.320 --> 0:09:10.440 marking them at one. There was one energy pe executives 0:09:10.440 --> 0:09:12.880 asked you, why is it that your portfolios marked at one? 0:09:13.160 --> 0:09:15.120 He said, well, we're looking through the cycle when we 0:09:15.160 --> 0:09:18.880 make our valuations once again. Isn't it pretty to think so? Right? 0:09:19.559 --> 0:09:21.920 I saw a quote actually that some eighty two percent 0:09:22.160 --> 0:09:26.079 of people in private equity use internal valuations rather than 0:09:26.120 --> 0:09:29.920 any kind of external benchmark. Why do investors let our 0:09:29.960 --> 0:09:33.800 investors just so desperate to believe that it's in this 0:09:33.880 --> 0:09:36.680 lack of volatility that they allow private equity firms to 0:09:36.679 --> 0:09:39.000 get away with it? Yeah, I mean, I think we're 0:09:39.040 --> 0:09:41.000 living in an age where everyone thinks back to the 0:09:41.040 --> 0:09:43.360 pain of O eight. I mean, I think it's very 0:09:43.440 --> 0:09:46.480 much on people's minds private equity. I think the Russell 0:09:46.520 --> 0:09:48.880 two thousand small cap index was down about sixty percent, 0:09:48.920 --> 0:09:51.679 peeked a trough and eight private equity was marked down 0:09:51.679 --> 0:09:55.360 about thirty percent. And so if you're sitting there on 0:09:55.400 --> 0:09:58.520 the investment committee of one of these pension funds or 0:09:58.600 --> 0:10:01.480 college endowments. You look back at that experience and you 0:10:01.559 --> 0:10:04.520 love private equity because that's what allowed you to sleep 0:10:04.559 --> 0:10:06.880 at night during that period, or to tell your committee 0:10:06.880 --> 0:10:08.520 that you were beating the market or you weren't down 0:10:08.559 --> 0:10:10.480 as much as the S and P. Right, you know, 0:10:10.480 --> 0:10:13.680 our and dowment did fine through the crisis. And of 0:10:13.720 --> 0:10:15.840 course it was a myth. But it's a myth that 0:10:16.040 --> 0:10:18.360 everybody is happy to believe in. I mean, markets are 0:10:18.360 --> 0:10:20.960 too volatile, right, I mean, nobody likes it when their 0:10:21.000 --> 0:10:24.200 portfolios down fifteen percent in three months, and this offers 0:10:24.280 --> 0:10:27.800 a pleasant alternative. Why do you think it continues with 0:10:27.840 --> 0:10:30.480 all of the warning signs that are building up to 0:10:31.000 --> 0:10:35.200 be so easy to sell private equity firms, institutional investors, 0:10:35.320 --> 0:10:38.440 It serves a pleasant fiction that a lot of us 0:10:38.480 --> 0:10:40.640 would like to believe in. It's like your quote from 0:10:40.640 --> 0:10:44.400 aus Son also rises. I think we'd like to believe 0:10:44.520 --> 0:10:50.559 that very smart, well educated Harvard Business School graduates can 0:10:50.640 --> 0:10:53.840 run companies better than other people, and that if we 0:10:53.880 --> 0:10:55.600 meet them and we really vet them, and then they 0:10:55.640 --> 0:10:57.319 go and buy these companies and they don't just buy 0:10:57.320 --> 0:10:59.720 a piece of them, right that they buy the whole company, 0:10:59.720 --> 0:11:02.000 and they really sit on the board and they work 0:11:02.040 --> 0:11:04.280 really hard at it, and they can improve the companies. 0:11:04.559 --> 0:11:07.280 David Swinson, who's the Yale endowment manager. So this is 0:11:07.320 --> 0:11:11.640 a superior form of capitalism. Yes, it's just better. It's managed. 0:11:11.800 --> 0:11:14.160 It's managed by just the type of people you think 0:11:14.160 --> 0:11:16.320 should be able to manage it very well. Okay, so 0:11:16.400 --> 0:11:19.160 we've addressed your first myth that these funds are not 0:11:19.280 --> 0:11:22.040 less volatile. It's just the accounting that actually helps them 0:11:22.120 --> 0:11:24.840 look less volatile, the accounting we're all actually willing to 0:11:24.880 --> 0:11:27.440 buy into. And now there's this myth. One of your 0:11:27.440 --> 0:11:30.120 other myths is that they actually can improve companies. And 0:11:30.120 --> 0:11:32.200 you've actually done a lot of work showing that that's 0:11:32.240 --> 0:11:35.120 not true. It's not just a belief of yours. And 0:11:35.160 --> 0:11:37.960 what's the most compelling thing you've found that made you 0:11:38.040 --> 0:11:40.000 say this just isn't true. What do I want to 0:11:40.040 --> 0:11:43.880 address this question? It's hard because private equity companies are private. 0:11:44.240 --> 0:11:47.000 So what I looked at is every private equity deal 0:11:47.440 --> 0:11:50.800 where the company has issued public debt. Okay, so when 0:11:50.800 --> 0:11:53.480 you issue public debt, you have to report your financials 0:11:53.640 --> 0:11:55.559 at the time of issuing the debt, right, which is 0:11:55.559 --> 0:11:58.640 when the transaction occurs, So you have the pre transaction financials, 0:11:58.840 --> 0:12:00.200 and then of course you have to report to the 0:12:00.240 --> 0:12:03.400 market what your returns are afterwards because the data is public. 0:12:03.800 --> 0:12:06.079 So I found about I think three hundred or so 0:12:06.360 --> 0:12:08.720 deals over the past a decade which I'd issued public 0:12:08.760 --> 0:12:11.199 dat so it's a pretty broad cross section. And then 0:12:11.320 --> 0:12:13.440 what I wanted to look at is pre acquisition what 0:12:13.520 --> 0:12:17.280 the financials were, and then post acquisition and see if, 0:12:17.280 --> 0:12:20.880 of course operational change is happening, and if it's happening 0:12:21.200 --> 0:12:25.040 at a magnitude which is driving this very superior performance 0:12:25.040 --> 0:12:28.000 to the public equity market. I figured it should be obvious, right, 0:12:28.040 --> 0:12:30.080 I mean, I shouldn't have to look too hard. So 0:12:30.360 --> 0:12:32.800 first I looked at trends in revenue growth YEA, and 0:12:32.880 --> 0:12:35.959 broadly what I found is that revenue growth slowed post acquisition. 0:12:36.160 --> 0:12:39.560 That's actually stunning, but it's not stunning if you think 0:12:39.559 --> 0:12:41.680 about it in a different way, which is that private 0:12:41.679 --> 0:12:44.200 equity firms want to buy good companies, so of course 0:12:44.240 --> 0:12:46.440 they're going to select for companies that have been performing well, 0:12:46.440 --> 0:12:49.079 which are going to be firms higher revenue growth than average. 0:12:49.320 --> 0:12:52.160 But if the world reverts to the mean and there's 0:12:52.160 --> 0:12:55.240 no skill, then you'd expect to see above average growth 0:12:55.240 --> 0:12:58.080 in the past and mean growth afterwards. That's what you see. 0:12:58.440 --> 0:13:00.960 And then you look at margins. So okay, well, maybe 0:13:01.200 --> 0:13:03.840 maybe the private equity guys aren't driving revenue. Maybe they're 0:13:03.880 --> 0:13:07.040 brilliant cost cutters, maybe their efficiency geniuses. There's such a 0:13:07.040 --> 0:13:09.760 thing as being a brilliant cost cutter. Maybe Okay, aggressive 0:13:09.800 --> 0:13:14.959 cost cutter, savage cost cutter, a predatory costcutter. I get it. 0:13:15.000 --> 0:13:17.480 But I saw basically no change in margins pre and 0:13:17.520 --> 0:13:20.360 post acquisition. So it wasn't like revenue growth was expanding. 0:13:20.360 --> 0:13:23.199 It wasn't like margins were expanding. So what did change, Well, 0:13:23.679 --> 0:13:27.000 very systematically, in every deal observed, there was a massive 0:13:27.040 --> 0:13:29.400 increase in debt. And with a massive increase in debt, 0:13:29.400 --> 0:13:32.120 a massive increase in interest payments, and because of the 0:13:32.160 --> 0:13:35.439 massive increase in interest payments, generally a contraction and investment spending. 0:13:35.920 --> 0:13:39.520 So if you think about what is the operational playbook 0:13:39.640 --> 0:13:43.160 from a data perspective, the operational playbook is to add 0:13:43.200 --> 0:13:46.679 debt to companies. That's it. That's the leverage buyout it's 0:13:46.720 --> 0:13:49.640 private equits just a story of debt. It's a story 0:13:49.679 --> 0:13:51.719 of debt. Does this make private equity sort of a 0:13:51.800 --> 0:13:54.360 parable for our times in the sense that this is 0:13:54.440 --> 0:13:57.280 the era of debt? Yeah? And I think that post 0:13:57.360 --> 0:14:00.480 oeight a sort of a set of interesting things happen, right. 0:14:00.520 --> 0:14:02.880 I mean, one is that interest rates obviously dropped a lot. 0:14:03.240 --> 0:14:06.080 Two is that the FED really intervened to abrogate the 0:14:06.120 --> 0:14:08.720 default cycles. There are fewer defaults in O eight than 0:14:08.760 --> 0:14:11.360 there were, for example, in OH three, So I think 0:14:11.360 --> 0:14:14.400 a lot of people got lulled into complacencies. They say, Okay, 0:14:14.400 --> 0:14:16.679 we can take risks with debt because interest rates were 0:14:16.720 --> 0:14:18.360 low and the Fed's going to bail us out, so 0:14:18.640 --> 0:14:21.400 why not go down the quality scale, take a little 0:14:21.440 --> 0:14:25.560 bit more credit risk. Surely it couldn't go wrong. And 0:14:25.880 --> 0:14:28.000 that's large to what we've seen in private equities. So, 0:14:28.240 --> 0:14:30.320 you know, the debt levels have just risen and risen 0:14:30.360 --> 0:14:35.680 and risen and risen. And because of regulation, the banks 0:14:35.680 --> 0:14:38.920 are no longer the ones public banks are no longer 0:14:38.960 --> 0:14:41.640 the ones providing the stat financing. Now it's in the 0:14:41.720 --> 0:14:45.760 private lending market, the business development corporations, the mid market lenders, 0:14:45.800 --> 0:14:49.760 the clos this whole heave of alternative lenders that are 0:14:49.760 --> 0:14:52.280 the ones providing this debt. And these are firms with 0:14:52.400 --> 0:14:54.800 very little track record. They're new firms, they don't have 0:14:54.840 --> 0:14:57.520 a lot of experience, they haven't gone through cycles. They're 0:14:57.600 --> 0:15:00.320 very aggressive, and they're willing to lend to all our 0:15:00.360 --> 0:15:03.480 companies more money than banks ever would have lent. And 0:15:03.520 --> 0:15:05.400 they're willing to do it. And this is sort of 0:15:05.400 --> 0:15:07.040 a very common thing that goes on in the industry 0:15:07.080 --> 0:15:10.400 on ProForma financials. So the FED, for example, put it 0:15:10.520 --> 0:15:13.400 rule in saying banks shouldn't lend a company is more 0:15:13.440 --> 0:15:16.720 than six times IBADA. So what happened in the wake 0:15:16.760 --> 0:15:18.960 of the crisis is that a lot of these private 0:15:19.040 --> 0:15:21.120 lenders and mid market lenders said, Okay, of course we're 0:15:21.160 --> 0:15:25.320 not going to lend more than six times EBITDA. But you, 0:15:25.600 --> 0:15:28.360 the private equity firm, tell us what IBADA is right, 0:15:28.360 --> 0:15:30.680 Because EBA does a made up number. It's not a 0:15:30.800 --> 0:15:33.120 it's not a net income, it's not cash from operations, 0:15:33.160 --> 0:15:36.240 almost whatever you want it to be, not quite exactly. 0:15:36.280 --> 0:15:40.000 So it's called ProForma ibnore all the bad stuff, earnings 0:15:40.000 --> 0:15:42.200 before all the bad stuff, and Moody has just done 0:15:42.200 --> 0:15:44.800 a study on this found that proformat ibada was generally 0:15:44.840 --> 0:15:49.400 about thirty percent higher than gap ibada, never lower. So 0:15:49.440 --> 0:15:51.840 I want to come back to this because this seems 0:15:51.880 --> 0:15:54.440 to hint to me at kind of round two of 0:15:54.560 --> 0:15:57.680 the shadow banking system that played such a dangerous role 0:15:57.680 --> 0:15:59.640 in the financial crisis of two thousand and eight. But 0:15:59.720 --> 0:16:03.200 you you said something when you were mentioning the lack 0:16:03.200 --> 0:16:06.040 of operational improvement to private equity firms that I found fascinating, 0:16:06.040 --> 0:16:08.560 which you said that there it's actually less investment, that 0:16:08.600 --> 0:16:11.040 they cut back on investment. And I find that really 0:16:11.080 --> 0:16:14.000 interesting because part of the marketing of private equity is 0:16:14.120 --> 0:16:16.760 that it's an escape from the short termism of the 0:16:16.800 --> 0:16:19.840 market that by allowing companies to be in private hands 0:16:19.880 --> 0:16:22.800 and to not have to meet quarterly earnings expectations, you 0:16:22.840 --> 0:16:26.080 can invest more and you can allow companies to take 0:16:26.120 --> 0:16:28.800 the big bets on businesses that we all want to 0:16:28.800 --> 0:16:31.200 see them make. Your data would seem to suggest that's 0:16:31.240 --> 0:16:34.480 not true. Lookt decreases your flexibility, right If you o 0:16:34.720 --> 0:16:37.600 lenders a huge amount of money, right, you don't have 0:16:37.600 --> 0:16:40.560 the flexibility to take some big, large scale bet And 0:16:40.880 --> 0:16:44.200 these firms are not taking out debt to fund building 0:16:44.200 --> 0:16:46.600 of a new factory. They're taking out debt to fund 0:16:46.840 --> 0:16:50.240 the acquisition of themselves. So I think that just simple 0:16:50.280 --> 0:16:52.520 logic would suggest that the firms that are going to 0:16:52.600 --> 0:16:55.240 invest a lot are not the most levered firms. How 0:16:55.280 --> 0:16:58.760 do you think about the returns garnered from the big 0:16:58.800 --> 0:17:01.040 dividend payments that it be comes such a feature of 0:17:01.080 --> 0:17:04.240 private equity because I might be wrong, but that strikes 0:17:04.280 --> 0:17:06.919 me as new. So back in the battle days of 0:17:06.920 --> 0:17:10.439 financial engineering, right, private equity firms didn't routinely do that. 0:17:10.480 --> 0:17:12.520 They didn't add on debt and pay themselves a big 0:17:12.520 --> 0:17:15.119 dividend and get their money out the way that happens 0:17:15.119 --> 0:17:18.199 in so many transactions today. Am I right about that? 0:17:18.240 --> 0:17:21.440 And is that a relatively new feature that is, yes, 0:17:21.720 --> 0:17:25.800 contributing to what returns there are, but also potentially quite 0:17:25.800 --> 0:17:28.480 problematic both for future returns and for the state of 0:17:28.480 --> 0:17:30.920 these companies. Yeah. So this is going to come back 0:17:30.960 --> 0:17:33.600 to the lessons learned from O eight, And one of 0:17:33.600 --> 0:17:35.880 the lessons learned from O eight by the private equity 0:17:35.880 --> 0:17:37.440 funds was that they bought a lot of things in 0:17:37.520 --> 0:17:39.960 a six or seven and then they couldn't get any 0:17:39.960 --> 0:17:42.439 money out of them until twenty ten or twenty eleven, right, 0:17:42.440 --> 0:17:44.880 so they were had this long period where they'd put 0:17:44.920 --> 0:17:47.679 cash in and they didn't get cash out, and that hurts. 0:17:47.720 --> 0:17:50.399 The key performance metric for private equity is called the 0:17:50.440 --> 0:17:52.920 internal rate of return right and time based, and it's 0:17:52.960 --> 0:17:55.159 time based, so you have to have a short window 0:17:55.240 --> 0:17:57.879 between when you put capital to work when you return it. 0:17:58.200 --> 0:18:01.119 And so all the IRR on the oh six and 0:18:01.119 --> 0:18:03.840 oh seven vintage funds were really low, and so a 0:18:03.840 --> 0:18:06.880 lot of firms convince convence study groups to say, okay, well, 0:18:06.880 --> 0:18:09.000 what are we going to do to make sure our 0:18:09.280 --> 0:18:12.080 RR numbers are attractive. And one of the things that 0:18:12.119 --> 0:18:14.240 they came away with is that you need to return 0:18:14.359 --> 0:18:16.840 capital early on in the investment. So you need to 0:18:16.840 --> 0:18:19.040 shorten the time between when you deploy capital when you 0:18:19.040 --> 0:18:21.159 give it back. So there are two ways to do that. 0:18:21.320 --> 0:18:23.520 One is you take out a subscription line of credit, 0:18:23.880 --> 0:18:26.639 so you buy a company, so you close in March, 0:18:27.119 --> 0:18:29.400 you borrow all the money you need for the closing, 0:18:29.760 --> 0:18:32.400 and then you wait until December to call the capital 0:18:32.440 --> 0:18:35.879 from your investors. So you've shortened the investment period by 0:18:35.920 --> 0:18:38.320 about nine months maybe, So that's a subscription line of 0:18:38.320 --> 0:18:39.840 credit that you do on the front end with yet 0:18:39.920 --> 0:18:42.640 more debt, with more debt, right, but it's short term debt, 0:18:42.640 --> 0:18:44.760 so it's pretty low rate, but it really helps the RR. 0:18:45.240 --> 0:18:47.200 And then the second thing is after about a year, 0:18:47.320 --> 0:18:50.840 if the operational metrics are good, and usually if there's 0:18:50.840 --> 0:18:53.520 anything you can generally forecast better, it's very short term 0:18:53.600 --> 0:18:55.880 results right after you buy something. So you buy it, 0:18:56.080 --> 0:18:58.480 maybe you make the quick fixes, ebit does up a 0:18:58.520 --> 0:19:00.520 little bit, You go back to the bank, you say, look, 0:19:00.520 --> 0:19:02.840 EVA does up five percent or timbercent. We can take 0:19:02.840 --> 0:19:05.199 out tim percent more debt, and we're going to do that. 0:19:05.200 --> 0:19:06.919 We're gonna refly at we're going to pair ourselves at 0:19:06.920 --> 0:19:09.280 dividend and then they get cash back really fast. So 0:19:09.320 --> 0:19:12.520 now their rrs looking great. And this has been it 0:19:12.520 --> 0:19:15.840 can't be understood how important that those dividend payments are 0:19:15.880 --> 0:19:18.679 to improving rrs. And that's really been one of the 0:19:18.720 --> 0:19:21.800 big drivers behind this. But that's actually frightening because it 0:19:21.800 --> 0:19:25.040 would suggest that the returns is meager as they have been, 0:19:25.400 --> 0:19:28.280 are also being juiced by tactics that may not be 0:19:28.440 --> 0:19:31.440 that are not sustainable. That's right, and hold periods. Actually 0:19:31.480 --> 0:19:34.439 this is interesting. So the underage Slifer, who is the 0:19:34.480 --> 0:19:38.320 most cited financial economist I think ever, and he says, 0:19:38.359 --> 0:19:43.240 there are three ingredients to a financial crisis. It's consensus, leverage, 0:19:43.760 --> 0:19:48.200 and illiquidity, and those are the dangerous trio. And obviously, 0:19:48.320 --> 0:19:50.840 you know we have consensus here, we have increasing leverage, 0:19:50.960 --> 0:19:53.840 and what's really scary is the illiquidity aspect of this. 0:19:53.920 --> 0:19:55.960 So one of the ways the private equity firms, you 0:19:56.000 --> 0:19:58.399 can think about measuring private equities, how long is the 0:19:58.440 --> 0:20:00.719 average hold period? So they buy company and then they 0:20:00.760 --> 0:20:02.800 sell it, and I think in O five and oh 0:20:02.880 --> 0:20:06.080 six is average hold here is about three or four years, right, 0:20:06.119 --> 0:20:08.120 So they buy it, sell it in three or four years. 0:20:08.480 --> 0:20:10.879 Now the genius to fix it in the music, right, 0:20:10.880 --> 0:20:13.439 they could do it that quickly. Now it's six or 0:20:13.520 --> 0:20:17.159 seven years. Okay, So these investments have gotten a lot 0:20:17.160 --> 0:20:19.000 more a liquid So that's another reason they're taking the 0:20:19.040 --> 0:20:21.680 dividends out and they're actually holding them longer. So why 0:20:21.720 --> 0:20:23.600 are they holding them longer? I would argue they're holding 0:20:23.640 --> 0:20:25.760 the longer because they can't sell them. They can't sell 0:20:25.760 --> 0:20:29.479 them at a higher peru, right, Hence the illiquidity right. 0:20:29.680 --> 0:20:32.760 Another interpretation, which they would say, is we're holding them 0:20:32.760 --> 0:20:36.400 longer because it just we're having such a wonderful operational 0:20:36.440 --> 0:20:40.040 impact that we realize that just within another two years, 0:20:40.160 --> 0:20:44.360