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ALTIF transcripts: Twilight of the private equity gods


Twilight of the Private Equity Gods

Private equity firms have amassed vast fortunes for their owners by snapping up companies in a rising stock market using ultra cheap debt. But what happens when values go down and interest rates rise? We talk to US investor and private equity sceptic Dan Rasmussen about the coming buyout Götterdämmerung.

(Dan has written recently on this and his note can be found here https://verdadcap.com/archive/private-equity-still-overrated-and-overvalued)

Presented by Jonathan Ford and Neil Collins.

With Dan Rasmussen.

Produced by Ewan Cameron and edited by Nick Hilton for Podot.

Sponsored by Briefcase.News

Neil Collins, Josh Buckland, Dan Rasmussen

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. Buying companies using lots of debt sounds like a brilliant idea when interest rates are falling and stock market valuations are going up. And that’s basically what private equity companies try to do for a living. But what about when interest rates are rising and the stock market is going down – which is what’s been happening recently? Does it mean that private equity-owned companies (increasingly a huge part of our economies) are in the soup? You wouldn’t think so because according to a recent story, billionaires are putting ever more of their money into buyout funds, private equity firms did a record $288bn worth of deals in the first quarter! And what about all the private equity investors that own all that stuff?

Ultimately, that’s actually you and me through our pension schemes. We vicariously pay big fees to private equity bosses, the likes of Steve Schwarzman in the US, because they’re supposed to make us rich. But what if they don’t? Have we been deluding ourselves all along that they know something we don’t? So we thought we’d trying to figure out some of these issues, and we’d get a real expert on the podcast. Dan Rasmussen is the founder of Verdad, a Boston-based fund management firm, who’s been a long-standing critic of the private equity industry, and has written a number of very interesting articles warning that private equity was overvalued. He’s also the author of a best-selling book, which feels somehow relevant here, though I’m not sure (inaudible) exactly explain why; It’s called American uprising, the story of America’s largest slave revolt. Dan, welcome.

Dan Rasmussen 01:50 Thank you. Glad to be on the show.

Jonathan Ford 01:53 Well, it’s very good to have you. Maybe we can start by talking about some of your views about private equity. I mean, let’s step back from where we are now in the markets for a second. Private equity has clearly been very successful over a long period. Is there anything you think that suggests they’re actually better at investing in companies?

Dan Rasmussen 02:12 I think less about, ‘are they better at investing in companies?’ than what type of companies are they investing in, and how and under what conditions does that style of investing work or not work? Right? We’ve seen all the data on active funds and mutual funds, right? I mean, they underperform passive index funds by and large, right? So I think it starts from the operating assumption that there might be genius, but on average, there should be no genius. And I think that’s got to apply to an industry as big as private equity. So what types of companies private equity firms buy? And how do they buy them? Well, there are really three things to know.

First, that they buy really small companies, usually 100th of the size of your average public company, right. So these are tiny little companies, and smaller companies go bankrupt more often, they’re riskier, they’re less diversified lines of business. So when you think small, you should think risky. The second thing they do is they put a lot of debt on these companies a lot of debt. Way more debt than you think. And it’s generally very low-quality debt. And it’s also interestingly floating rate debt, which we should talk more about. And so you should be also thinking; very risky. And then the third thing is private equity used to be a sort of obscure niche. And if you went into private markets, you know, you were buying from less sophisticated sellers, generally for much lower prices. But now private equity is a massive, massive industry.

So about half the time, you’re buying from other private equity firms.

Neil Collins 03:32 It always seems to me that private equity are like the desert island entirely populated by antique dealers, who spend the whole time selling, buying and selling the stuff and they were all making a profit.

Dan Rasmussen 03:45 Yeah, and I think investors might wonder how they benefited from, you know, one fund selling to another and then paying 20% carry on the sale and then paying nucleus on the next one. There’s a lot of turnover, right and (inaudible).

Jonathan Ford 03:57 Yeah. But just to press you a little bit more on the industry in the way it does its business. If you go back to 1990 (so a long time ago), a man called Michael Jensen, who was quite influential, wrote a paper where he basically espoused the idea that private equity was actually a better way of running companies. He said it was a superior form of ownership. And he came out with a whole load of reasons like they had more skin in the game, they were close to the companies they were invested in.

And this idea of the discipline of debt, which is basically you couldn’t run the company in a kind of mad profligate way if you’d borrowed almost all the money that you’d needed to buy it, because you’d go bust if you tried to run this in a profligate way. Do you think there was any validity in any of that? Or do you just think that private equity is pretty much the same as everyone else?

Dan Rasmussen 04:49 Well, I think the use of data is real. Right? So are there pros and cons to that? Yes, right. I think he’s right; a company with more debt, the management is going to cut costs and be more cautious about spending, because they know they’ve got those interest payments looming and so I think that’s totally true. On the other hand, debt should make companies much more likely to go bankrupt and much less resilient in a recession, which should also be true. So there are trade-offs for everything. Where I probably most take issue with Michael Jensen’s work is he’s so focused on the idea that people have to be incentivized to do the right thing.

And specifically, he’s famous not just for thinking about private equity is more than more aligned owners, because they’re majority shareholders, but he’s probably more famous for promoting specific types of executive pay, specifically options-based compensation. And saying, gee, you know, an executive just getting paid two or $3 million a year isn’t really that motivated to do a good job. But if you tell him that over five years, he can make $100mn, then he’s going to be really motivated to do a good job. And what a brilliant idea. And I think Jensen more than anyone else is responsible for the massive rise in CEO pay. I’m not sure that it’s made any difference at all other than increasing income inequality, and perhaps enriching the few people that got to be CEOs and probably at (inaudible).

Neil Collins 06:02 As far as I can see, there’s no correlation between CEO pay and performance. You thought that they were there to perform anyway.

Jonathan Ford 06:09 Look at this podcast, it’s basically running on fresh air.

Neil Collins 06:13 Yeah, exactly. I particularly liked your recent article on the subject, particularly referring back to your previous one, where basically you said you got it all wrong. Your diagnosis was spot on, and unfortunately, all the industry came to the opposite conclusion to you. And they were right. And you were wrong.

Jonathan Ford 06:35 So Dan, I think it was in 2018, you wrote an article in an American magazine, where you basically said that you thought private equity as a sort of asset class was overvalued, and over-borrowed and was heading for trouble. And then very recently, probably a few weeks ago, now, you basically did a follow-up note where you said, ‘maybe I was too early, and it could still happen now, or maybe I was wrong.’ Where are you on that thought?

Dan Rasmussen 07:06 Yes. Well, I think, you know… in 2018, I said; look, there are a few things going on, you know, private-equity valuations have gone through the roof. So now private equity folks are paying a little higher prices than public companies, which is a little bit insane, given that they’re buying such small companies, right? So is your local pharmacy worth as much as CVS, you know? No! CVS should be worth more because they’ve got thousands of CVS, a large company should always in theory be worth more than a tiny little thing. And so for private equity to be buying these tiny little companies that prices that are higher than the S&P 500 seems to me to be wrongheaded.

And second, that we’re using massive amounts of debt, which seems extremely risky. And increasingly, interestingly enough, they’ve been concentrating their investments in growth equity sectors; tech and healthcare. But after I wrote that private equity has had a really good few years! A very good last four years, right, they’ve actually been over the trailing three years beating the public markets by quite a bit. And so the question is how could I have been so wrong? You know, in 2018, you know, what sort of happened – and why was that wrong? And it’s actually very simple why I was wrong, which is just that everything I said in that article got worse from my perspective.

So valuations went up, debt levels went up. And it turns out, when valuations go up, that people that bought in 2018, the things they own were worth more. And I said, you know, like, gee, maybe this can continue on forever, but the prices of private equity firms are paying are probably double, literally double the prices they were paying in 2010. And the amount of debt they’re taking on to do that is literally double. And again, the debt they’re taking on is floating rate debt.

Jonathan Ford 08:35 By floating rate debt, you mean debt where the interest rate fluctuates? Right?  Prevailing change, right? So right now, for example, those bonds that have been issued to back private equity companies would see their interest rates, their coupons going up.

Dan Rasmussen That’s right

Jonathan Ford The interest rates going up. Resetting upwards, with what’s going on at the Fed.

Dan Rasmussen 08:57 A lot of them are tech companies, okay. So you know, I don’t know what percent but I guess 40 or 50% of the deals are software tech related these days, right? Which is crazy, right? How can they be so concentrated in one sector, but they are! These companies have borrowed, you know, huge, huge amounts of money, often eight or ten years worth of profits that they’ve borrowed, and they borrowed it with floating rates. And so you say, okay, gee, you know, one of the things that really bailed out private equity in my view is COVID, right? Because a lot of the craziest things they were doing were concentrated in the tech sector, and COVID rewarded the tech sector. So everything that might have looked stupid or crazy or risky in 2019 by 2021, was looking brilliant.

Neil Collins 09:34 So you’re essentially doubling down on your original thesis, having been wrong so far. I have to say that I’m on your side. I agree entirely with your thesis that the elastic has been stretched so far, by this double effect of increasing valuations and dirt, cheap debt. Both of those things look to me to be unsustainable. And I’m really interested to see that you are, as I say, doubling down on your original thesis. And I wonder whether you’re getting any traction as a result of your latest piece.

Dan Rasmussen 10:15 Well it’s quite interesting, the critique of private equity gets a lot of interest from academics and journalists, and no interest from actual investors. Everyone in the investment community thinks that private equity is the best thing since sliced bread. And they might read your thing amusingly, or, you know, the third-year analysts might send it around and say, isn’t this funny, our bosses are really idiots. But by and large, no one believes that no one cares. And the question is why?

The reason for it is actually quite simple; private equity doesn’t mark their assets in the same way that public companies do. So public companies, you know, they’re traded on a public exchange. So markets are down 3% today or something, but private equity doesn’t trade on a daily basis, right, in a private equity firm, I own the same company for five years. So what they do is every quarter, they have their accountant say what it’s worth, and they might benchmark that to some public companies, and where they trade or whatever, and what their recent financials are. But it turns out that when accountants are looking at how much something is worth, the volatility of the accountants views tend to be much, much lower than the volatility of the markets.

Neil Collins 11:15 Funny that! Yeah, just remind me who’s paying the accountants?

Dan Rasmussen 11:19 Private equity firms are paying the accountants. But, but so, you know, if the market is down a lot, you know, private equity might not be down at all. And so what private equity historically has had its volatility that looks about like corporate bonds – past the volatility roughly of say The S&P 500. Whereas small-cap stocks have almost twice the volatility of the s&p 500. You sort of look at it, and you say, well, these are tiny, little companies, they should be more volatile. But in fact, they’re half as volatile.

Jonathan Ford 11:47 And they’re also very highly leveraged. Because whenever they should be pinging around like ping pong balls,

Dan Rasmussen 11:53 I often think about it sort of from a psychological effect, you know, what lessons have investors learned? So let’s say you’re an energy investor, okay. And 2010, you start investing in energy, and you think energy is the best thing since sliced bread. And then the 2015 crash happens. And you think, okay, wow, everything I like, just got cheaper, let me double down. And then energy prices go down more, right? And so everything you bought at what you thought was the low is now doing even worse, and then COVID happens. And, you know, it’s the same sort of thing happens, right? And by that time, you’ve had so many painful experiences, you think, well, now oil is down so much, it’ll never come back, I should just quit and switch into some other industry, right? Everyone’s sort of done at that point.

Neil Collins 12:33 The market can stay wrong longer than you can stay solvent. Exactly.

Dan Rasmussen 12:37 But then think about the inverse. So think of tech investors, right? If you had just bought every dip in tech since 2010, you’d be a very wealthy man right now. Because every time that tech is dipped a little bit, it’s gone back to new highs, with COVID being the most dramatic dip and then rally. And so what tech investors learn by 2021 is the tech always goes up and buy every dip. They haven’t learned anything about risk management, they haven’t been encouraged to switch jobs. They’ve just been taught that what they’re doing is so brilliant that if the market goes against them, they should double down. And private equity is similar, right?

Because private equity, you never see that volatility. There’s never been a bad experience in private equity. Right? It just keeps chugging upward and upward relatively gradually and keeping roughly with the public market. And so investors absolutely love it. There’s nothing they like more, it just goes up. And it goes up with the volatility of corporate bonds, even though it has, in theory, a heck of a lot more risk. So to them, this is the least risky thing they do. They love it, it makes sense.
It’s not as volatile or crazy as the public markets.

Jonathan Ford 13:31 Okay, so one thing which, though, does baffle me, and that’s always baffled me in looking at this industry, is the fact that huge amounts of capital come from, if one looks at the US, from pension funds, pension schemes. These guys, in theory, are supposed to be thinking this stuff through and what you’ve just said is essentially that basically, pension schemes are paying very high fees which make a billionaire out of somebody like Schwarzman in return for returns, which are effectively over the medium term being little better than the stock market.

They could have invested directly for much lower sort of fee drag in an ETF. And yet, why are they doing this? Why do they think it’s such a good idea to funnel so much money at these Wall Street guys? Is it simply because of the volatility, the fact that they don’t have that unpleasant 10% dip when there’s a nasty move in the markets, that their private equity portfolio just grinds on? Mysteriously, as you say, basically, without ever going up or down very much?

Dan Rasmussen 14:40 I think that’s one of the reasons they love it. Right – its that reduced volatility. Secondly, how was your private equity portfolio doing is a really hard thing to answer, right? Because you can always say, well, I invested three years ago, but it’s a ten-year life so we’ll know in seven years. And if you’re constantly reinvesting in private equity you’d never really know until the end when they liquidate their portfolios, what it’s worth. And then even then benchmarking is kind of difficult because you have to say, okay, well, when did they buy this? What if I put in the s&p at the same time? And what if I sold it then right?

We actually have to build a spreadsheet to calculate whether it’s better or worse than the s&p 500. Whereas every mutual fund or everything else in the world, it just reports it automatically, right? It’s like in your little database, so you don’t even need to know. And so it’s actually very easy to know if you’re underperforming or not. And it turns out that a lot of people are underperforming. Markets are really hard. But markets seem easy and private markets, right, they just sort of consistently seem to win.

Neil Collins 15:34 Which is of course, why the trustees of these large funds, feel so comfortable with private equity, because you can’t actually benchmark them at all well, and there’s this wonderful sort of mystique about them. Oh, well, you know, our funds are invested in private equity – and you know, these people are very smart., and they do all sorts of clever things that you wouldn’t do in the normal stock market. And I think that people who are concerned about their backside, being sued if things go spectacularly wrong, this is the sort of thing that comforts them to no end. They think, yes, well, we must be doing the right thing.

Dan Rasmussen 16:15 And you’re also part of a club. Okay, you own ETS, so does my dentist. I mean what fund is that? If you’re a limited partner at Blackstone, that’s quite nice!

Neil Collins 16:24 And I’m sure they get well looked after the races, and the opera and other terrible places like that.

Jonathan Ford 16:33 Can we just Dan talk about for a second about the Ponzi scheme question. I mean, I think that was the expression that was used by another fund manager. Not you, a guy I think at Amundi who said that, basically these sort of… they’re called secondary sales. So where I’m private equity firm A, I have an investment, and instead of selling it to the stock market, or to a corporate buyer, when I’m done with it, I sell it to another private equity firm, who then runs it for three more years, and then sells it back to a third private equity firm. And he said, well look, with your point about valuations, being you know, marked to accountant; that means you can have companies going through a number of hands, and you never really know what those things are worth, because they’re just popping from one valuation to the next. Do you think there’s a real risk that these things can become significantly unanchored from reality through this process?

Dan Rasmussen 17:30 Absolutely. I mean, how could it not become unanchored from reality? Right? I mean, I think one of the big questions, right is that private equity fundraising in aggregate is increasing every year. So your pool of buyers keeps going up and having more money to invest with and debt has been getting cheaper and more available. So you’re multiplying equity by a multiplier of what’s actually available, given leverage levels. And so they’ve never had a contraction in money flowing into the asset class, at least since? Oh, 08/09. Right. And I think that’s the big question, right? What is fund ten is smaller than fun nine, what if in aggregate, the money invested in private equity in the 2023 vintage year is less than the 2022 vintage year, what impact does that have on valuations across the industry, right? Because this is an illiquid asset class that’s sensitive to fund flows.

And I think Andre Schleifer at Harvard said, there are three ingredients to a financial crisis. You need consensus, right, everybody has to agree that something’s a really good idea. Shaq, we’ve got that with private equity. Two, there needs to be leverage, right? So you need leverage, right? We’ve got that in spades. And not only do we have leverage, we have leverage from these new firms called private credit firms, which are taking FAR more risks than any bank ever would. And then third, he said, you know, you need a limited exit opportunity. So once people actually start selling, they can’t get out. Well, how are you going to get out of your private equity stakes at scale, if the market turns and people turn against private equity? Well, it’s gonna be really hard. And that’s what would create a panic selling thing. So Schleifer says, well, what do you need to catalyse that? He said, well, you need a salient event that changes consensus. So consensus goes from being this is the best thing since sliced bread to ah shoot, I need to get out of this.

Neil Collins 19:12 So how about rising interest rates as the catalyst that breaks this cycle?

Dan Rasmussen 19:18 I think there’s potential for that. I mean, I think probably the smarter PE firms hedged their interest rate exposure at some point. So they probably have as many years until those hedges burn off until they actually feel the pain. But the bigger question is when they sell it because whoever’s buying it has to get financing at market rates. So presumably, that, you know, market financing is going to be much more expensive and thus valuations that are able to pay are going to be lower.

So I think it doesn’t come necessarily in the form of your current portfolio companies, it comes in the form of how much you’re able to sell things for and contracting valuations. And so I think probably the bigger catalysts are related, but it’s that private equity is way overweight tech, and tech has been the leader of the market sell-off this year. And so you know, the NASDAQ  is down 30 or whatever, you know, what’s private equity down, which is levered tiny little things that aren’t as good as the NASDAQ companies, is it down 40 is down 35? I don’t know. Right, but it’s something bad. Now, they’re not going to tell you that that’s true.

Neil Collins 20:13 No, no, because our private equity fund, of course, is hugely superior to the run of the mill, private equity fund, as you will know, because you have had the intelligence to buy into it.

Dan Rasmussen 20:25 And they just had the accountants look at it. And none of it’s actually down that much!

Jonathan Ford 20:28 What do you think, what do you think? Because everything you’ve just said, sort of suggests this could go on for years and years and years. Do you think there’s anything which suggests that the timing could be nigh?

Dan Rasmussen 20:40 Certainly it is. I mean, so let me point to a few things that indicate that it is. So first, there have been these crossover funds, they’re called. Okay, so a crossover fund, they do public and they do private. So most of this is more venture-like, so they invest in hot tech companies and public markets. And then they cross over to private markets to buy younger, hotter tech companies. This is the Tiger Globals of the world, right. Those firms are down 50% plus this year, and those were like the marquee players in the crossover space.

Jonathan Ford 21:11 And that’s because some of that portfolio they have to mark to market with the market, their public investments are stuffed.

Dan Rasmussen 21:17 Their public stuff, they’re marked down 50. And they’re right now still saying oh our private stuff isn’t down as much. Right? In theory, I would say the price is going to be down more than the public stuff, not less. Yeah. And they will have to acknowledge that right? I mean, actually, relatively shortly, because they’re under so much public scrutiny right now.

And they’re getting so much money, investor redemptions. Right. And so if the crossover space is getting hurt that bad, and you look at the venture people and the venture, people are saying, this is nuclear winter, this is awful, you know, look at what they’re… I mean, they’re panicked, because they’ve seen what has happened at the later stages. The venture exit was to crossover, the crossover access public markets, the public markets are down 50! What are the privates down, more than 50? What is the venture stuff that’s pre-the stage where the crossover fund could have bought them, more than 50? And then you think, okay, how much of private equity right like sort of what’s in Blackstone or TPG, or Thoma Bravo’s funds, looks like what Tiger owns. And I don’t know what percent that is, but it’s probably more than 10 and less than 50. But having that much of your fund in stuff that looks like that, it’s gotta be down a lot. And so I think the reckoning might be right here already, and whether they’ll escape it or not, I don’t know.

Jonathan Ford 22:29 Can be quite difficult to get out once you’ve sunk your capital in, unless you can find someone to buy you out of it.

Dan Rasmussen 22:35 Private Equity does have the advantage of being able to quote unquote, ‘kick the can down the road.’  Just say, you know, we decided that the company is doing so well, we don’t need to sell it in 2022. We’re gonna keep just holding it because it’s such a great company until 2030. And then we’ll sell it.

Neil Collins 22:51 And you’re locked in!

Dan Rasmussen 22:52 You’re locked in. So what are you going to say about it? Right? You know, there’s potential for that, right. But I think the risks they took and the amount of debt they took on is so great that it’s going to be a lot harder to kick the can down the road in this crisis. They’re going into this crisis with twice the debt, on average, per company that they had in 2007. I mean, 2008 and 2009 was bad, right? So it’s just gonna be twice as bad. I don’t know, it’s not a good setup.

Neil Collins 23:16 Now, in that article, you did have a sort of glimmer of hope for where the poor benighted investor might look for the value, which was in what you described as small value stocks, which have also taken a bit of a pasting. What’s the justification for that view?

Dan Rasmussen 23:37 Yeah. So I think that if you see what’s kind of going on in terms of market dynamics right now, people are talking about a shift from growth to value. And the reason they’re talking about that is that a lot of us look at the valuations of growth stocks relative to value stocks. So what sort of spread, and the spread between growth and value was really high in 1999, for example, and then it actually reached higher than 1999 levels in 2021.

So those of us who are practitioners of value investing, say, you know, gee, as growth comes down value is going to outperform, just like it did for years after 1999. Because everybody said, I don’t want to own some boring industrial company. I don’t want to own some company in Japan, you know, all I want to own is companies that leave out the vowels in their name that run strange tech platforms in the cloud. Markets are fickle, and they change their preferences. And I think we’re living through a big change in preference where people no longer want growth stuff.

Neil Collins 24:34 I have to say that I sort of agree with most of your thesis.

Jonathan Ford That’s high praise, by the way

Neil Collins That was a long time in finance with Jonathan Ford and Neil Collins, editing and production is by Nick Hilton, and our sponsorship partner is briefcase dot news. Join us again next week.


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