All that Glisters…
Presented by Jonathan Ford and Neil Collins,
With Sachin Khajuria.
Produced and edited by Nick Hilton for Podot.
In association with Briefcase.News
Jonathan Ford 00:06
Hello, and welcome to a long time in finance with Jonathan Ford and Neil Collins, in partnership with briefcase dot news, the service that brings intelligent curation and analysis to your media monitoring. When I worked as a banker in the late 1980s, private equity, at least in Britain, was still a cottage industry. And most of what it did was buying up the unwanted divisions of large conglomerate companies. Now, of course, it’s a giant global industry, not just doing those buyouts, that’s buying companies largely financed by debt. Private Equity itself lends to companies these days and invests in specialist areas such as infrastructure and property. Now, we recently did a podcast with an American fund manager Dan Rasmussen, who believes that private equity has turned into a bubble driven by low interest rates and rising stock market valuations. This Dan thinks will eventually burst leaving a lot of wreckage behind and if you haven’t listened to that podcast do go and give it a listen. We are now of course, in a world where interest rates are climbing and valuations are going down. So in the interest of balance, we thought we’d invite on Sachin Kathuria, former partner of Apollo one of the world’s largest buyout groups, who recently wrote a book called Two and 20, why the masters of private equity always win. Now Sachin takes an opposite view to Dan, he thinks broadly that private equity companies have pioneered a superior form of investing and ownership. And that far from collapsing, they’re going to become an even more dominant part of our economies in future, it’s only fair to say that I reviewed two and 20 in the Financial Times, where I said that it was a book that seemed to be aimed mainly at young hopefuls who wanted to work in private equity. And thus it preached to the already converted. So it’s very sporting of you to search and to come on the podcast to debate some of these issues. So welcome.
Sachin Khajuria 02:01
Thank you so much. It’s great to be here.
Jonathan Ford 02:04
So I just wanted to start by going back to one of the more striking lines in two and 20, where you say one point in private equity, capitalism has perfected a version of the virtuous circle. Now, that’s quite a claim. And I just wonder what you meant by that.
Sachin Khajuria 02:21
So the book is about the psychology of winning at the best firms. It’s not about the whole industry, any more than writing the FT is not about all of journalism, or being a politician doesn’t represent all politicians. My experience at good private equity firms is that they have created something of a virtuous circle. That’s why they keep growing, the good performers, the ones that can beat the market – they attract more assets under management, only because they perform. If they didn’t perform consistently, if they could not beat the market. And I mean, the public market benchmarks, easy benchmarks for most people to understand, if they cannot continue to provide a greater unit of return per unit of risk they take on, they would not get repeat business, that sticky money, that loyalty, that repeat subscription from their investors, when they get that those assets under management, when they grow, they tend to attract better and better people who work there. So it used to be that in private equity, you’d find a lot of people who used to be bankers, and they would join private equity firms after a few years investment banking. And they probably went to a prestigious university in the Ivy League, or Oxford and Cambridge and one of the other great universities around the world. Now it’s a lot more diverse. Now, you get people joining who have a background in life sciences, have a background in infrastructure, who have a background in credit, they actually could have worked for banks, at quite a senior level, but now think that their better home to develop their business isn’t a private markets firm, but a private equity firm that does multiple strategies. And so you find better people join. As better people join over time, and it’s a slow process, they will tend to continue to outperform. And so the circle goes round. The other part of this is what’s happening at the client. And remember, the client is the pension fund investor, or the sovereign wealth fund, or the high net worth individual or family or increasingly, it’s going into retail. The client has an increasing need for a higher return in their portfolio, because the rest of their portfolio is not giving them the investment return they need to service their obligations. And so that’s really the positive dynamic I think you get at the best private equity firms.
Neil Collins 04:42
So this is a great sales pitch, I have to say, but I am hugely sceptical about the ability of any investment organisation to produce consistent above average returns with one or two very extreme exceptions, they will revert to the norm over time, insofar as outsiders are allowed to see what’s going on. Because a lot of the information is not public information. So you can’t really tell what they’re up to.
Jonathan Ford 05:15
I agree with that. The first thing is, it’s very hard for us as outsiders really to form that much of a view about what’s going on within the industry between one firm and another, because most of the data that’s available to the outside world is aggregate data. And if you look at that aggregate data, what you can conclude is returns which used to be, you know, we’re talking after fees here, we can come back to that, after fees were two or three percentage points higher than the public markets, have actually trended pretty much to be in line in more recent years. Now, you may argue, well, that’s irrelevant, because you’re bundling in a whole bunch of poor-performing firms and funds, and I’m just looking at the very best ones. But that’s all we can really look at. And also I just take issue slightly with the idea that one should disaggregate in the way you are doing, because I think private equity is clearly a big feature and has all sorts of implications for the way businesses run and so forth, saying, well, you should just focus on the very best ones is like saying you should judge the stock market, not on what it does the stock market index, but on the performance of a few top performing stocks.
Sachin Khajuria 06:25
So, Neil, your comment about, you know, the scepticism of certain for firms to able to consistently outperform? The basic answer to that it’s time will tell. Whichever benchmark you use, there are a number of firms that are able to perform very, very well. I don’t know of people who advocate that all private equity is great in the same way that people don’t say, put all of your eggs in the stock market. But I think the premise of what you’re saying, Neil, I kind of disagree with it. I think it’s a little bit, you know, one of those misconceptions where you’re setting it up as oh, private equity saying it’s better than everything else. No, I don’t think it can be better than everything else. I mean, that’s not what at debate.
Neil Collins 07:05
That’s not what I said that, but you’re not trying to paraphrase what I said are you?
Sachin Khajuria 07:08
I don’t think it’s a competition between whether one form of investing is superior or another form of investor is inferior, you need to have a balanced portfolio. And as your portfolio hopefully grows, and the needs hopefully grow, because you have more obligations, you have more investment needs, you have more money to put to work, I think more people will look at active management, as opposed to just passive management. And within active management, I think that a number of private investment firms, private equity firms, have been able to perform very well over long periods of time. You know, can you say that they’ll always be able to do that? No, but they have, and the point of the book, for example…
Neil Collins 07:48
But before you leave that point, if you have a large number of firms doing this, then there will be some who have performed well over a long period. Whether it’s any guide to the future, of course, is another matter entirely. But statistically, you will get some who have shown considerable outperformance over a long period.
Sachin Khajuria 08:09
Yeah, we’re saying something, which is the point of the book is to try to help people understand, because it’s a people business. It’s not automated, like passive investing, a lot of passive investing is
Neil Collins 08:21
Why, in your book, you do not have any concrete examples, rather than just theoretical ones.
Sachin Khajuria 08:29
They’re not theoretical. In many industries, you find that you cannot breach certain rules of confidentiality. And what’s important is not necessarily whether the deal was based in Milan, or in Manhattan, or wherever, or whether it was a biscuit company, or it was a cookie company, or what kind of company it was. What’s important is the lesson and the story that the deal actually teaches. And what we’re very upfront about right up front of the book is we say, Look, we cannot breach confidentiality. So what we’ll do, these are real deals. They’re all real deals. But we have to change details, because we’ve got to protect a lot of information. But what’s important is the story. And there are plenty of stories in the book where deals go wrong. What’s important is the story, right?
Jonathan Ford 09:13
But what that does show which is a consistent bugbear of mine is the fact that it’s an incredibly secretive business. And it is also a $10 tn one. So it’s not a cottage industry as it was in the 1980s. It’s actually a very significant part of the economy. But one of the other points which I want to come to in your book is you talk about incentives. Are they over rewarded for what they do? And you say, no, absolutely. You say no, they are really talented people and they earn their returns. I suppose what I would say is, it’s very hard to know whether that is true unless we really know what’s going on under the hood. Now, the British Venture Capital Association of USA did a study and they came to the conclusion which is very interesting. They said roughly a third of the returns come from leverage. A roughly a third came from beta; so the stock performance of the underlying stock market and rather third came from residual, which was a bunch of things from buying low etc. So these are the people who supposedly know the facts! That they are buying low selling high operational improvements and so forth. So that absolutely explains why everyone wants to go and work in this industry because they’re all getting absolutely massively over-awarded. But it doesn’t explain that they’re adding very much to the economy.
Sachin Khajuria 10:31
You know, 20% of zero profit for your investors is zero. So if you haven’t made any cash profit, remember, this is not a hedge fund.
Neil Collins 10:38
You do get the 2%, which is quite a nice thing to be getting on with…
Sachin Khajuria 10:42
20% of 0 is 0. If you’re on a bunch of deals, whether you get paid deal by deal, or you’re incentivized across the whole fund, and none of your deals make money, and the fund doesn’t make any profit for your pension fund investor or whoever your investors are, you get no carried interest because you’ve made no money. Now, how likely are you as a group of people to get money back to you as investors the next time you raise money, your track record will be awful. And it’s cash in cash out. It’s not a paper game, there’s no changing watermarks or so on, you hand over 100 million pounds or dollars or euros, and you get back 200 million. And let’s say that’s after they’ve taken a cut, which is let’s say 20% cut’ depending on the strategy of the firm, could be less, could be more, but often it’s less as well, can be 15%. So they’ve actually made real cash profit for you. I haven’t seen the study you’re talking about internally, people talk about maybe roughly a third, and you’ve seen a lot of industry figures say this kind of thing in public, maybe roughly a third comes from operational improvements. In other words, the business is performing better on things like revenue, size, profit, growth, investment, etc. Maybe a third is the way the capital structure works. So you’ve got debt, which provides certain benefits and risks. And maybe a third is the way you enter and the way you exit. So the price at which you pay if you pay a particularly good price, a Smart Price, or what I like to call a kind of smart bargain for a good business. And whether you’ve exited smartly, you know, you buy a house, you wait for the top of the market, you sell the house at the top of the market and not the bottom of the market. Now, if the firm consistently doesn’t perform that well, and you don’t make that much, then you’re going to ask yourself the next time they’re raising a fund whether you want to recommit.
Neil Collins 12:35
But I think a lot of these people who ultimately make the decisions about where to invest these pension funds are not really experts in their fields. And the idea that they can give it to somebody else is a great comfort to them. If they can convince themselves that they will do better than the markets, then so much the better. But they are keen to be persuaded. Because a lot of the trustees, certainly the trustees, will not be experts. And they have these huge sums of money, which they have to invest on behalf of the pensioners, they are looking for the sort of comfort blanket that private equity can provide.
Sachin Khajuria 13:21
Being a trustee or an investment manager of a pension fund is a very transparent job. It’s a very transparent industry, if you are making bad decisions, those decisions will be very public. As soon as the results of that pension fund are published. It’s not my experience that pension funds make decisions, which are you know, just the easy decision to make. You know, I’ve been in a lot of fundraising meetings where they asked, you know, tough questions, and they try to back firms that they really believe in because they’re really backing people that they believe in, one of the biggest questions that institutional investors have about private equity firms is what’s happening with the people, what’s happening with the leadership? What’s happening with the governance? I noticed this person joined this person left, you started this new strategy, who’s going to run it? How can you use the same people when actually something slightly different than you’ve been doing before? So I’ve seen actually the opposite, which is scrutiny. But that’s not to say that I’m sure that mistakes are made, or you know, there might be some of that going on?
Jonathan Ford 14:19
Okay, so I want to touch on another thing, which is actually related to this to do with benchmarks, because I have to say one of the things which I as somebody who occasionally looked at this industry have marvelled over it for many years is the extent to which pension funds pile in because as you’ve observed, this is an enormous industry, multi trillion industry, and not all that money is going to Blackstone but it’s also going to other firms as well. And yet, as I said before, the returns are not that great relative to the public markets, and the pension funds continue to pay very high fees to get that service. Now, one of the thoughts I had was that actually what is going on here, it’s just sort of regulatory arbitrage, which is the pension funds don’t like volatility for exactly the reason and you say it in the book, you say pension funds don’t like it. They don’t like having to report up and down funds. What private equity does, because it locks up your money in an illiquid structure for a period of time, is it offers you protection from that volatility. And that is a service, I suppose, which you could argue that some pension fund trustees will be prepared to pay for. The real question I have about that is whether that volatility is really suppressed, given that private equity firms largely invest in small to medium-sized companies, which they then leverage, which would imply that they ought to be more volatile in the market, not less. And is it not the case that the real suppression of volatility comes from the fact that the accountants, the auditors who are hired to value these firms, basically are very obediently, continue to value them roughly at what was paid for them, and therefore protect the private equity funds from the volatility, which is really there. And there’s one piece of evidence, which is a live piece of evidence, I suppose, which is what was going on at Tiger Global, which was a company that invested in listed tech stocks, and unlisted tech stocks through a sort of private equity part of its business. Whereas the tech stocks and listed tech stocks it is invested in have fallen by about 60% this year. Basically, the unlisted holdings sort of not really moved very much. And people have been criticising Tiger Global and said, Well, what’s the story here? How can it be that these two tech businesses, they can’t be that different? One of them is getting an absolute caning and the leverage dprivate ones are holding their value.
Sachin Khajuria 16:43
So number one, I don’t think that a selling point of private equity is invest in us because we are less volatile, and therefore you can report less volatility. I don’t think that at all.
Jonathan Ford 16:56
You say so in your book! You say it’s one of the services you talk about, as you say, we invest brilliantly well, and the investments we make, are amazingly not as valid volatile as the stock. That’s the service that pension funds like!
Sachin Khajuria 17:11
That’s not the service, the service is put capital in our hands. And we will return a good risk-return outcome for you and your investors. An advantage of an unlisted investment is that it doesn’t have the day-to-day volatility, or even second-to-second volatility of a listed investment. That doesn’t mean it’s a selling point. The point is the performance. And one of the other advantages is that you don’t get in private equity, the same volatility as you would in the public markets, which has a number of benefits. Okay. And again, it’s not a competition, it’s not put about all your eggs in one basket. It’s not saying put all your money in private markets or public market’s. It about in a balanced portfolio, should you be putting some of your allocation into unlisted investments, because they give you a good risk-return outcome. And I think, if you can pick the right firms and funds the answer to that is yes, you should consider it. So number two, the major firms do adjust quite significantly, mark to market valuations per quarter. Okay, so through COVID, through this year, there have been pretty significant adjustments in valuation, sometimes they can be up or down 10, 20, 30% why they’re not done every second? Because they’re unlisted. But the major firms do have this marked market change. So you will see significant changes in portfolio value. And if they’re not doing well, or if, for example, it just happens to be a very volatile time. For example, suddenly, there’s a one-in-100-year pandemic, or suddenly there’s a war in Ukraine, or there’s a drastic change in the macro environment, you will see big changes in valuation quarter to quarter. The advantage is that you don’t need to sell tomorrow, you can hold on until times are better, you can work on that portfolio and exit at a more opportune time.
Neil Collins 19:09
Now, I understand that. And that, obviously, is a recipe for avoiding market panics.
Jonathan Ford 19:15
But it’s also, it’s also something where the investor given that they are locking up their capital, should expect a significantly higher rate of return than the one that the industry delivers.
Sachin Khajuria 19:25
There should be a premium for having your money locked up relative to money you can take out straightaway. And therefore, what we look at in the book is the firm’s that are able to provide that premium over the public markets. If you’re putting money into an unlisted investment and you’re getting a worse outcome than if you just invested in an ETF or some other cheap public investment strategy where you’re paying a few basis points of fees in management fees and no performance fee. Then you’re going to wonder what after a while while you’re doing it. But hopefully you have a bit of education, a bit of smarts, a bit of good guidance to be able to put money into firms and funds, where you are getting compensated for that money being locked up. And that’s really what we focus on.
Neil Collins 20:11
You feel much cleverer as a result of doing this, because you have decided that these people are very clever. So rather than putting it into an ETF, we’re going to give it to these people who are masters of the universe.
Jonathan Ford 20:24
In your book, you talk about the management fee, which Neil mentioned earlier, the 2%, and how that’s used to cover costs. And because of the massive expansion of all these firms and funds, it is now a substantial source of profit. So in 2019, I think Blackstone’s in their account, they basically disclose that they made a $500 million profit from the 2% management fee. Is it right that what is designed as a cost-covering measure should in itself become a massive source of profit?
Sachin Khajuria 20:55
One of the most important things to realise is that if you compare the private equity industry, when it started to the industry today, private markets, it’s like comparing an old Motorola brick phone to the latest iPhone, it’s not even close. What these funds are doing today is quite different than they were doing when they first started. They’re not just doing high yield debt and buyouts. They’re doing investing in all kinds of industries, they have to invest and they have to grow. And because they’re public, the big ones at least, they also have to return a profit to their shareholders. A lot of these firms are now available in certain indices. So if you buy an index, you can get the exposure to some of these firms’ stock and even buy some of their debt in certain indices. And so as public firms, they’re going to be for-profit public firms, so you can expect them to make a certain profit. The question is whether the scale of those management fees is appropriate relative to their size relative to what they’re doing.
Jonathan Ford 21:50
But some of them are even selling off participations. In that situation, I’d go, why am I paying this 2%?
Sachin Khajuria 21:55
But remember, you’ve got to differentiate between an investor in the firm and an investor in the funds. So one of the key questions people often ask is, if you’ve got some capital, is it better for you to buy stock in that private equity firm? Or is it better for you to put money in the funds? And of course, there’s probably only one class of stock that you can buy, if you can buy it, and they’re probably, you know, 20 30, maybe more? And the answer is, it depends on the firm. And there you’ve got to ask yourself whether the performance of the funds is strong enough to warrant your, your dollar or your Euro, or your Yen.
Neil Collins 22:31
Presumably, once you list the manager, you leave them vulnerable to somebody coming along and bidding for them with private equity.
Sachin Khajuria 22:40
It’s a great idea. Often the ownership is still quite concentrated. And so we haven’t seen a lawsuit.
Neil Collins 22:50
Because it hasn’t had long enough…
Sachin Khajuria 22:52
We haven’t seen a hostile takeover or private equity firm yet.
Neil Collins 22:54
That was a long time in finance with Jonathan Ford and Neil Collins, editing and production by Nick Hilton. And our sponsorship partner is briefcase dot news. Join us again next week.