1 00:00:00,400 --> 00:00:03,080 Hello and welcome. You are listening to Patrick 2 00:00:03,080 --> 00:00:06,800 Boyle on Finance, a podcast exploring ideas from 3 00:00:06,800 --> 00:00:10,320 quantitative finance, examining events occurring in markets 4 00:00:10,320 --> 00:00:14,080 right now and financial history to see what lessons can be taken 5 00:00:14,080 --> 00:00:17,400 away, including interviews with some of the most interesting 6 00:00:17,400 --> 00:00:20,960 people in the world of finance. To learn more about the podcast, 7 00:00:20,960 --> 00:00:29,120 visit on finance.org. A friend of mine sent me a link 8 00:00:29,120 --> 00:00:33,240 last week to a CNBC interview with the giant motivational 9 00:00:33,240 --> 00:00:36,880 speaker Tony Robbins, where he extolled the virtues of 10 00:00:36,880 --> 00:00:40,600 investing in private equity. Robbins argued that private 11 00:00:40,600 --> 00:00:44,840 equity provided high returns with low risk to rich investors 12 00:00:45,080 --> 00:00:48,360 and that these great returns would soon become available to 13 00:00:48,360 --> 00:00:52,520 ordinary investors and, surprisingly, with no fees. 14 00:00:52,520 --> 00:00:55,760 In fact, I was confused as he seemed to be saying that you 15 00:00:55,760 --> 00:00:58,120 would receive fees as an investor. 16 00:00:58,400 --> 00:01:02,440 All of these rich idiots are paying fees, but somehow regular 17 00:01:02,440 --> 00:01:06,160 people won't have to. I haven't watched CNBC in quite 18 00:01:06,160 --> 00:01:09,160 some time, but the whole thing came off as being like a 19 00:01:09,160 --> 00:01:11,280 commercial. For decades, you know, private 20 00:01:11,280 --> 00:01:14,200 institutions, big institutions, pension funds, ultra wealthy 21 00:01:14,200 --> 00:01:16,720 people have had access, but the general public has not had 22 00:01:16,720 --> 00:01:18,840 access and most of them don't even understand the impact. 23 00:01:18,840 --> 00:01:22,560 For example, in the S&P 500 for the last 35 years, we know we've 24 00:01:22,560 --> 00:01:24,880 compounded at 9.2%. It's pretty darn good. 25 00:01:25,080 --> 00:01:27,680 You're doubling your money about every eight years, but you've 26 00:01:27,680 --> 00:01:30,880 got 14.2%. Not with these guys with average 27 00:01:30,880 --> 00:01:33,680 private equity. So imagine getting 50% more per 28 00:01:33,680 --> 00:01:39,320 year compounded for decades. So you don't have to fight to 29 00:01:39,320 --> 00:01:42,320 get into these funds anymore. You can actually purchase the 30 00:01:42,320 --> 00:01:44,800 fund, the companies themselves, you can become a general 31 00:01:44,800 --> 00:01:46,160 partners. You know you're a limited 32 00:01:46,160 --> 00:01:48,080 partner when you're an investor in one of these funds. 33 00:01:48,400 --> 00:01:52,320 But you like the CEO, the CFO, and they make 2% when they make 34 00:01:52,320 --> 00:01:54,720 you money or not, and they make 20% of the upside. 35 00:01:54,720 --> 00:01:57,320 And people give that because the amazing returns. 36 00:01:57,600 --> 00:01:59,280 Well, now you get the two and 20. 37 00:01:59,680 --> 00:02:02,560 It's pretty extraordinary. So I own 65 different firms, 38 00:02:02,560 --> 00:02:04,880 some of the biggest in the world now that I'm a partner in in 39 00:02:04,880 --> 00:02:07,120 that area and anyone can start to do this. 40 00:02:07,480 --> 00:02:11,039 Now, I know very little about Tony Robbins, but as you can 41 00:02:11,039 --> 00:02:13,720 probably guess, I was instantly skeptical. 42 00:02:13,920 --> 00:02:17,240 These claims fly in the face of all financial theory. 43 00:02:17,520 --> 00:02:20,920 To start with, it's not obvious why investing in private 44 00:02:20,920 --> 00:02:24,640 companies would provide much higher returns than investing in 45 00:02:24,640 --> 00:02:28,720 publicly listed companies. Private companies are still just 46 00:02:28,720 --> 00:02:32,520 businesses and subject to the business cycle like all 47 00:02:32,520 --> 00:02:35,880 investments, and many of the private companies were even 48 00:02:35,880 --> 00:02:39,960 taken private by investors paying a premium to the public 49 00:02:39,960 --> 00:02:43,000 shareholders. It's really not obvious why a 50 00:02:43,000 --> 00:02:47,160 privately held business would be less risky than a listed 51 00:02:47,160 --> 00:02:50,520 business, or that an investor should expect to get higher 52 00:02:50,520 --> 00:02:54,640 returns with lower risk. Now I did some Googling and I 53 00:02:54,640 --> 00:02:58,200 have to tell you, I'm actually quite impressed by Tony Robbins. 54 00:02:58,360 --> 00:03:01,880 He's made some big promises in the past, and at least in one 55 00:03:01,880 --> 00:03:04,200 case, appears to have lived up to them. 56 00:03:04,480 --> 00:03:07,840 More than 30 years ago, Tony Robbins wrote a book called 57 00:03:08,000 --> 00:03:11,760 Awaken the Giant Within, and straight away I thought, well, 58 00:03:11,840 --> 00:03:15,320 who can do that? And the answer is Tony Robbins. 59 00:03:15,320 --> 00:03:19,840 It seems to He's 6 feet 7 inches tall, An actual giant. 60 00:03:20,000 --> 00:03:23,240 There's no one better qualified to write a book like that. 61 00:03:23,440 --> 00:03:25,600 In fact, I'll have to go out and buy one. 62 00:03:25,840 --> 00:03:28,480 I realized that I probably shouldn't have been so 63 00:03:28,480 --> 00:03:31,600 skeptical. Anyone with a basic knowledge of 64 00:03:32,320 --> 00:03:37,280 history knows that giants like Tony Robbins probably have a 65 00:03:37,280 --> 00:03:41,120 goose that lays golden eggs, and so maybe we should buy some of 66 00:03:41,120 --> 00:03:44,400 his magic beans. It has to work out, right? 67 00:03:45,080 --> 00:03:47,840 So first up, what is private equity? 68 00:03:48,080 --> 00:03:51,240 Are the returns really as high as Tony Robbins says? 69 00:03:51,400 --> 00:03:54,600 And is the risk as low on top of that? 70 00:03:54,600 --> 00:03:58,680 When people say that private equity firms are evading taxes 71 00:03:58,880 --> 00:04:01,560 and ruining the economy, are they right? 72 00:04:02,160 --> 00:04:06,040 Well, private equity is quite simply investing in companies 73 00:04:06,040 --> 00:04:08,560 that are not listed on a Stock Exchange. 74 00:04:08,880 --> 00:04:12,120 Private equity funds can be broken down into venture 75 00:04:12,120 --> 00:04:15,720 capital, which involves investing in startups, which are 76 00:04:15,720 --> 00:04:19,959 high risk, high return growth capital, which involves taking a 77 00:04:19,959 --> 00:04:23,880 minority stake in a mature company that either needs this 78 00:04:23,880 --> 00:04:27,760 capital to grow or needs it to commercialize a new product 79 00:04:27,760 --> 00:04:30,680 line. And finally, leveraged buyouts, 80 00:04:30,840 --> 00:04:34,640 where the fund uses a large amount of debt to purchase an 81 00:04:34,640 --> 00:04:38,720 entire company. In an LBO, the buyer usually 82 00:04:38,720 --> 00:04:42,880 uses the company's assets as collateral for the debt and 83 00:04:42,880 --> 00:04:46,640 plans to pay it off with the company's future cash flow. 84 00:04:47,320 --> 00:04:51,520 We'll be focusing mostly on LB OS today, as that's what most 85 00:04:51,520 --> 00:04:54,440 people mean when they talk about private equity. 86 00:04:54,680 --> 00:04:58,560 And there's a long history of transactions like this as people 87 00:04:58,560 --> 00:05:01,920 have been borrowing money to buy out businesses as long as 88 00:05:01,920 --> 00:05:05,920 businesses have existed. J Pierpont Morgan's acquisition 89 00:05:05,920 --> 00:05:11,840 of Carnegie Steel in 19 O1 for $480 million is considered the 90 00:05:11,840 --> 00:05:15,840 first true major buyout. And the first leveraged buyout 91 00:05:15,840 --> 00:05:19,920 was the purchase of PAN Atlantic Steamship Company and Waterman 92 00:05:19,920 --> 00:05:24,920 Steamship by McLean Industries in 1955, where the buyer 93 00:05:24,920 --> 00:05:29,560 borrowed $42 million for the transaction and were able to pay 94 00:05:29,560 --> 00:05:34,240 off $20 million of that debt as soon as the transaction closed 95 00:05:34,240 --> 00:05:37,480 using the cash and assets of the acquired companies. 96 00:05:38,040 --> 00:05:42,640 Up until the 1980's, the LBO remained an obscure financing 97 00:05:42,640 --> 00:05:46,280 technique as since the Great Depression companies had kept 98 00:05:46,280 --> 00:05:49,760 their debt loads low. Robin Wigglesworth described in 99 00:05:49,760 --> 00:05:55,920 the FT how KKR's 1978 purchase of Who Day Industries using only 100 00:05:55,920 --> 00:06:01,240 $1 million in equity for the $380 million purchase was 101 00:06:01,240 --> 00:06:05,280 private equity's genesis moment. The deal was structured such 102 00:06:05,280 --> 00:06:09,120 that the target firm itself was responsible for repaying the 103 00:06:09,120 --> 00:06:12,400 massive debt. This deal showed just how 104 00:06:12,400 --> 00:06:15,960 ambitious even a small investment company could be and 105 00:06:15,960 --> 00:06:18,360 became a blueprint for the industry. 106 00:06:18,600 --> 00:06:22,040 Wigglesworth describes how the deal documents became widely 107 00:06:22,040 --> 00:06:25,680 read on Wall Street by people like Stephen Schwarzman, then a 108 00:06:25,680 --> 00:06:29,320 partner at Lehman Brothers. Schwarzman wrote in his book 109 00:06:29,320 --> 00:06:33,320 King of Capital that he had read the deal prospectus, looked at 110 00:06:33,320 --> 00:06:36,440 the capital structure, and realized the returns that could 111 00:06:36,440 --> 00:06:39,240 be achieved. He described it as a Rosetta 112 00:06:39,240 --> 00:06:41,720 Stone for how to do leverage buyouts. 113 00:06:42,080 --> 00:06:45,920 Over the next decade, the LBO became the biggest business on 114 00:06:45,920 --> 00:06:49,520 Wall Street. From the early 1960s through 115 00:06:49,520 --> 00:06:53,880 until the late 1970s, American executives participated in a 116 00:06:53,880 --> 00:06:57,720 wave of acquisitions where they built massive diversified 117 00:06:57,720 --> 00:07:00,520 conglomerates. The ranks of middle management 118 00:07:00,520 --> 00:07:04,440 at these firms grew and profitability began to decline 119 00:07:04,440 --> 00:07:07,440 as the businesses became too unwieldy to manage. 120 00:07:07,760 --> 00:07:11,320 Many of these businesses were trading at a discount to net 121 00:07:11,320 --> 00:07:15,720 asset value and the early LB OS involved buying these businesses 122 00:07:15,720 --> 00:07:19,120 up on the cheap and breaking them up by selling off the 123 00:07:19,120 --> 00:07:21,680 pieces for something closer to fair value. 124 00:07:22,040 --> 00:07:26,200 This breakup approach led to a media backlash against the greed 125 00:07:26,200 --> 00:07:28,400 of these so-called corporate Raiders. 126 00:07:28,800 --> 00:07:33,440 The character Gordon Gekko in the 1987 film Wall Street was 127 00:07:33,440 --> 00:07:36,600 based on a number of high profile corporate Raiders of the 128 00:07:36,600 --> 00:07:39,840 day and was supposed to be the villain of the film. 129 00:07:40,160 --> 00:07:43,880 The writers were shocked when the public saw Gekko as a hero 130 00:07:43,880 --> 00:07:46,200 rather than as a villain for his line. 131 00:07:46,280 --> 00:07:49,600 Greed is good. So how did these deals work? 132 00:07:49,840 --> 00:07:53,440 Well, while every deal is unique, the one common element 133 00:07:53,440 --> 00:07:57,560 is financial leverage or borrowed money to complete the 134 00:07:57,560 --> 00:07:59,880 transaction. Some portion of the debt 135 00:07:59,880 --> 00:08:04,240 incurred in the LBO is secured by the assets of the acquired 136 00:08:04,240 --> 00:08:08,600 business and its cash flows are used to service the buyer debt. 137 00:08:08,960 --> 00:08:13,360 With an LBO, the acquired company helps pay for itself and 138 00:08:13,360 --> 00:08:16,720 for this reason the deals were sometimes called bootstrap 139 00:08:16,760 --> 00:08:20,360 acquisitions. The high level of debt helps the 140 00:08:20,360 --> 00:08:24,080 private equity company to achieve acceptable returns for 141 00:08:24,080 --> 00:08:28,600 their investors and maybe more importantly, provided tax 142 00:08:28,600 --> 00:08:31,240 savings. Due to the tax deductibility of 143 00:08:31,240 --> 00:08:35,760 interest expense, Private equity companies often encourage top 144 00:08:35,760 --> 00:08:39,200 company management to invest alongside them in the deal, 145 00:08:39,440 --> 00:08:43,120 better aligning management incentives with investors. 146 00:08:43,360 --> 00:08:46,680 It's argued that the large interest and principal expenses 147 00:08:46,680 --> 00:08:50,720 incurred put management under pressure to improve operating 148 00:08:50,720 --> 00:08:54,160 efficiency, and that the discipline of debt can force 149 00:08:54,160 --> 00:08:59,080 management to cut costs, divest non core businesses and invest 150 00:08:59,080 --> 00:09:02,200 in technological upgrades to improve efficiency. 151 00:09:02,760 --> 00:09:06,400 While private equity firms will be flexible in terms of what 152 00:09:06,400 --> 00:09:10,360 they invest in, the leverage nature of their business means 153 00:09:10,520 --> 00:09:14,480 that strong cash flow generation and a strong asset base will 154 00:09:14,480 --> 00:09:18,160 matter a lot, as you can't really borrow without these 155 00:09:18,400 --> 00:09:22,360 attractive valuations, along with relatively little existing 156 00:09:22,360 --> 00:09:26,560 debt will matter too. One of the key drivers of 157 00:09:26,560 --> 00:09:29,880 returns to early leverage buyouts was that not only did 158 00:09:29,880 --> 00:09:33,800 expensing the interest payment on debt reduce the tax burden on 159 00:09:33,800 --> 00:09:37,040 the acquired company, but what was known as the general 160 00:09:37,040 --> 00:09:41,960 utilities doctrine meant that a buyer who bought at least 80% of 161 00:09:41,960 --> 00:09:46,000 the stock of a corporation could treat the transaction for tax 162 00:09:46,000 --> 00:09:50,280 purposes as liquidation of the corporation and purchase of its 163 00:09:50,280 --> 00:09:53,680 assets. Corporations liquidating their 164 00:09:53,680 --> 00:09:57,320 assets were not subject to capital gains tax on the 165 00:09:57,320 --> 00:10:01,440 appreciation in value on their assets and what this meant was 166 00:10:01,440 --> 00:10:04,280 that the value of assets could be written up and re 167 00:10:04,280 --> 00:10:08,280 depreciated, reducing the taxes owed by the company. 168 00:10:08,840 --> 00:10:12,480 These newly leveraged firms would have to pay little if any 169 00:10:12,480 --> 00:10:15,240 corporate income tax for the life of the buyout. 170 00:10:15,480 --> 00:10:19,040 This meant that no business turn around was even needed. 171 00:10:19,240 --> 00:10:23,760 The same stream of corporate income now shielded from tax 172 00:10:23,920 --> 00:10:27,440 could be used to service the massive debt taken on in the 173 00:10:27,440 --> 00:10:32,120 transaction with the belief that the taxpayer was subsidizing 174 00:10:32,120 --> 00:10:35,760 leverage buyouts. Ronald Reagan's Tax Reform Act 175 00:10:35,760 --> 00:10:41,120 of 1986 repealed the general utility's doctrine, reducing the 176 00:10:41,120 --> 00:10:45,440 profitability of these deals. We're reducing tax rates by 177 00:10:45,440 --> 00:10:49,320 simplifying the complex system of special provisions that favor 178 00:10:49,320 --> 00:10:53,520 some at the expense of others. Restoring confidence in our tax 179 00:10:53,520 --> 00:10:57,480 system means restoring and respecting the principle of 180 00:10:57,480 --> 00:11:01,960 fairness for all. We'll be back. 181 00:11:01,960 --> 00:11:04,840 After a quick break. It's like our brains have a mind 182 00:11:04,840 --> 00:11:06,160 of their own when it comes to money, right? 183 00:11:06,160 --> 00:11:07,520 Yeah. It's crazy. 184 00:11:07,560 --> 00:11:11,240 We're diving into that today, how our brains really deal with 185 00:11:11,240 --> 00:11:13,520 money. We're going deep on this one, 186 00:11:13,520 --> 00:11:16,880 looking at money and how we decide behavioral research. 187 00:11:17,480 --> 00:11:20,760 This stuff is like eye opening. Seriously, it turns out our 188 00:11:20,760 --> 00:11:23,480 brains aren't always rational, especially with money. 189 00:11:23,720 --> 00:11:25,760 No kidding. So what's the deal with that? 190 00:11:25,760 --> 00:11:28,680 Why are we so bad at making, you know, sensible financial 191 00:11:28,680 --> 00:11:30,480 decisions? Well, our brains are kind of 192 00:11:30,480 --> 00:11:33,200 lazy in a way. They love taking shortcuts. 193 00:11:36,920 --> 00:11:39,560 OK. So who invests in private 194 00:11:39,560 --> 00:11:42,880 equity? Tony Robbins told the CNBC 195 00:11:42,880 --> 00:11:46,720 audience that regular people don't get a look in, It's just 196 00:11:46,720 --> 00:11:49,480 the ultra wealthy. Well, when we look at the 197 00:11:49,480 --> 00:11:53,200 biggest investors in private equity, it's a mix of pension 198 00:11:53,200 --> 00:11:56,320 funds and sovereign wealth funds, which is basically the 199 00:11:56,320 --> 00:12:00,560 money of ordinary people. Just over half of the money in 200 00:12:00,560 --> 00:12:04,720 private equity comes from public pension funds, 1/4 comes from 201 00:12:04,720 --> 00:12:07,320 sovereign wealth funds. Then we've got insurance 202 00:12:07,320 --> 00:12:11,600 companies, foundations, private pension funds, banks and so on. 203 00:12:11,800 --> 00:12:16,360 CPP, the Canadian Pension plan, is a huge allocator to private 204 00:12:16,360 --> 00:12:20,520 equity, as is CalPERS, the Californian public pension plan. 205 00:12:21,080 --> 00:12:25,160 Broken down by country, the US, Canada and Singapore are the 206 00:12:25,160 --> 00:12:28,760 biggest allocators. So when Tony asks why do the 207 00:12:28,760 --> 00:12:32,240 richest people in the world get the greatest assets, it's maybe 208 00:12:32,240 --> 00:12:35,440 a bit misleading. If you invest in private equity, 209 00:12:35,520 --> 00:12:39,360 you're getting to invest like a teacher or a firefighter, not 210 00:12:39,360 --> 00:12:42,160 Jeff Bezos. If you want to invest like Jeff 211 00:12:42,160 --> 00:12:46,320 Bezos, you have to put almost all of your money in Amazon, a 212 00:12:46,320 --> 00:12:50,360 publicly listed stock. So what do the investment 213 00:12:50,360 --> 00:12:54,440 returns look like then? Tony said the returns are 50% 214 00:12:54,440 --> 00:12:58,120 higher than public equities, but that's not really accurate. 215 00:12:58,360 --> 00:13:02,280 Firstly, private equity funds don't actually report total 216 00:13:02,280 --> 00:13:04,560 returns like other fund managers do. 217 00:13:04,840 --> 00:13:09,480 They report the funds IRR, or internal rate of return. 218 00:13:10,120 --> 00:13:13,800 When an investor commits to invest in a private equity fund, 219 00:13:14,080 --> 00:13:16,600 their money doesn't go in right away. 220 00:13:16,800 --> 00:13:20,320 The first four to five years of a private equity fund's life are 221 00:13:20,320 --> 00:13:24,440 known as the investment period. In this period, the fund usually 222 00:13:24,440 --> 00:13:28,440 draws down committed capital to make investments into portfolio 223 00:13:28,440 --> 00:13:30,960 companies. Although they usually call in 224 00:13:30,960 --> 00:13:34,640 most of the committed capital during the first five years, it 225 00:13:34,640 --> 00:13:38,920 can sometimes take them longer to invest at all, such as if 226 00:13:38,920 --> 00:13:41,920 they feel there are no good investment opportunities. 227 00:13:42,280 --> 00:13:45,000 Warren Buffett explained the problem with this at a 228 00:13:45,000 --> 00:13:49,360 shareholder meeting in 2019, saying when you commit the money 229 00:13:49,360 --> 00:13:53,160 to private equity firms, they don't take the money, but you 230 00:13:53,160 --> 00:13:55,600 pay a fee on the money that you've committed. 231 00:13:55,880 --> 00:13:59,160 You really have to have that money ready to come up with at 232 00:13:59,160 --> 00:14:01,280 any time. And of course, it makes their 233 00:14:01,280 --> 00:14:04,560 returns look better if you sit there for a long time in 234 00:14:04,560 --> 00:14:08,120 Treasury bills, which you have to hold because they can call 235 00:14:08,120 --> 00:14:11,600 you up and demand the money and and they don't count that in 236 00:14:11,600 --> 00:14:15,960 their IRR calculations. There are other tricks, too. 237 00:14:15,960 --> 00:14:19,880 The Wall Street Journal described in 2018 how the funds 238 00:14:19,880 --> 00:14:23,200 often don't call the cash as soon as an investment is 239 00:14:23,200 --> 00:14:27,360 identified, instead borrowing money to make the investment in 240 00:14:27,360 --> 00:14:30,920 what's called a bridge loan, tapping investors for cash 241 00:14:30,920 --> 00:14:33,520 later. According to the Journal, this 242 00:14:33,520 --> 00:14:36,720 was originally done to make capital calls more predictable 243 00:14:36,720 --> 00:14:39,360 for investors. But while the practice doesn't 244 00:14:39,360 --> 00:14:44,000 boost a cash profits, it does decrease the time during which 245 00:14:44,000 --> 00:14:48,080 investors cash is held in the fund, delaying the moment when 246 00:14:48,080 --> 00:14:52,440 the clock starts ticking from an IR or calculation standpoint, 247 00:14:52,640 --> 00:14:55,840 which can result in a significant boost in the 248 00:14:55,840 --> 00:15:00,440 internal rate of return. So as impressive as reported IRS 249 00:15:00,480 --> 00:15:04,400 often look, that's not the actual return that an investor 250 00:15:04,400 --> 00:15:07,320 gets. Internal rate of return is quite 251 00:15:07,320 --> 00:15:10,280 a problematic metric. It's a bit like yield to 252 00:15:10,280 --> 00:15:13,960 maturity on a bond where there's a built in reinvestment 253 00:15:13,960 --> 00:15:17,760 assumption which may not play out in real life as the amount 254 00:15:17,760 --> 00:15:20,640 of capital invested changes over time. 255 00:15:20,960 --> 00:15:25,040 It's not very easy to know average private equity returns 256 00:15:25,200 --> 00:15:28,600 as the funds themselves don't report returns to a central 257 00:15:28,600 --> 00:15:32,360 database, and the series of returns that people analyse 258 00:15:32,360 --> 00:15:36,120 contains survivorship bias. When people claim that private 259 00:15:36,120 --> 00:15:40,200 equity outperforms public equities by 3% a year. 260 00:15:40,440 --> 00:15:43,080 A big problem with that number is that most of that 261 00:15:43,080 --> 00:15:47,040 outperformance happened 20 or more years ago when the industry 262 00:15:47,040 --> 00:15:50,280 was much smaller and there was more low hanging fruit. 263 00:15:50,560 --> 00:15:53,600 Over the last 20 years, the outperformance has been closer 264 00:15:53,600 --> 00:15:58,680 to 1% a year after fees, which while not as impressive, is 265 00:15:58,680 --> 00:16:02,480 still good and should compound out into significantly greater 266 00:16:02,480 --> 00:16:08,000 wealth for investors over time. Sadly, using pitch book data, it 267 00:16:08,000 --> 00:16:11,680 would appear that private equity stopped outperforming the S&P 268 00:16:11,680 --> 00:16:16,320 515 years ago and over the last year significantly 269 00:16:16,320 --> 00:16:21,000 underperformed the stock market. A 2014 paper from Oxford 270 00:16:21,000 --> 00:16:25,080 University made the argument that investors had been using 271 00:16:25,080 --> 00:16:29,440 the wrong benchmark, the MSCI All Country World Index, to 272 00:16:29,440 --> 00:16:33,760 judge private equity returns, as that index has a weighting of 273 00:16:33,760 --> 00:16:38,440 about 50% for U.S. stocks and private equity funds invest 274 00:16:38,440 --> 00:16:42,360 about 80% of their money in the United States, which has 275 00:16:42,520 --> 00:16:45,880 outperformed international stocks over that period. 276 00:16:46,160 --> 00:16:50,000 Additionally, private equity typically invests in smaller 277 00:16:50,000 --> 00:16:52,960 companies than are in the big US indices. 278 00:16:53,160 --> 00:16:57,520 And most importantly, public equities use considerably less 279 00:16:57,520 --> 00:17:01,280 leverage than the companies in a leveraged buyout fund. 280 00:17:01,840 --> 00:17:05,280 The paper argued that you could not judge private equity returns 281 00:17:05,280 --> 00:17:07,760 without taking these factors into account. 282 00:17:08,079 --> 00:17:12,640 The author concluded that if the benchmark is changed to small 283 00:17:12,640 --> 00:17:16,960 and value indices and is levered up, the average buy out fund 284 00:17:17,079 --> 00:17:20,280 underperforms by three-point 1% per annum. 285 00:17:20,640 --> 00:17:23,119 And that's not what we're trying to do at all. 286 00:17:23,280 --> 00:17:26,640 How are we going to awaken the giant within if we're growing 287 00:17:26,640 --> 00:17:31,800 3.1% less than our benchmark? Building on this research, a 288 00:17:31,800 --> 00:17:35,680 paper in the Financial Analyst Journal dug even deeper. 289 00:17:35,960 --> 00:17:39,440 The authors used a more complete database of returns and 290 00:17:39,440 --> 00:17:42,680 conducted a thorough bottom up analysis of the risk 291 00:17:42,680 --> 00:17:46,000 characteristics of the underlying companies in buyout 292 00:17:46,000 --> 00:17:48,960 funds. This paper found that the 293 00:17:48,960 --> 00:17:53,920 underlying companies that buyout funds invest in have on average 294 00:17:53,920 --> 00:17:57,040 smaller market caps than their public counterparts. 295 00:17:57,280 --> 00:18:01,280 Their sector composition is materially different to big US 296 00:18:01,280 --> 00:18:04,760 indices, for example, significantly overweight 297 00:18:04,760 --> 00:18:08,760 consumer discretionary stocks and underweight the financial 298 00:18:08,760 --> 00:18:12,880 sector and their leverage is much higher than that of public 299 00:18:12,880 --> 00:18:16,800 companies in the same sector. When they adjusted for size, 300 00:18:16,800 --> 00:18:21,400 sector composition and leverage of portfolio companies in buyout 301 00:18:21,400 --> 00:18:25,320 funds, the outperformance was reduced by more than half. 302 00:18:25,560 --> 00:18:29,360 Finally, when they adjusted for the vintage of the funds, they 303 00:18:29,360 --> 00:18:33,440 found no evidence of private equity outperformance. 304 00:18:34,040 --> 00:18:37,440 That then leads us to Tony Robbins argument that private 305 00:18:37,440 --> 00:18:41,160 equity is low risk. If the returns are the same as 306 00:18:41,160 --> 00:18:44,600 the returns of a leveraged investment in small cap stocks 307 00:18:44,880 --> 00:18:48,680 because the funds make levered investments in small cap stocks, 308 00:18:48,920 --> 00:18:52,320 then an investment in private equity should be riskier than 309 00:18:52,320 --> 00:18:55,760 the average portfolio. One risk that you're taking when 310 00:18:55,760 --> 00:18:59,200 investing in private equity is that your investment is 311 00:18:59,200 --> 00:19:02,640 illiquid, meaning that you can't necessarily get your money back 312 00:19:02,640 --> 00:19:06,240 quickly if you want it. Now, normally when an investor 313 00:19:06,240 --> 00:19:10,040 takes an incremental risk like this, they expect to get an 314 00:19:10,040 --> 00:19:12,600 incremental return in compensation. 315 00:19:12,840 --> 00:19:16,400 It doesn't appear that with private equity investors are 316 00:19:16,400 --> 00:19:19,480 being compensated for the illiquidity risk that they're 317 00:19:19,480 --> 00:19:22,920 taking. This leads us to Cliff Osnes 318 00:19:22,920 --> 00:19:26,920 argument that private equity investors and fund managers are 319 00:19:26,920 --> 00:19:30,800 playing a dangerous game of what he calls volatility laundering. 320 00:19:31,440 --> 00:19:35,040 Asness argues that the illiquidity of private equity 321 00:19:35,040 --> 00:19:38,640 and the fact that the assets are held at prices that in no way 322 00:19:38,640 --> 00:19:42,320 relate to real world asset values was historically 323 00:19:42,320 --> 00:19:46,360 acknowledged in the industry as a bug, but today this bug is 324 00:19:46,360 --> 00:19:48,960 being sold to investors as a feature. 325 00:19:49,160 --> 00:19:52,680 He points out that investors usually get paid to accept a 326 00:19:52,680 --> 00:19:57,520 bug, but are expected to pay up to receive a feature in market 327 00:19:57,520 --> 00:20:00,000 sell offs. Private equity funds are very 328 00:20:00,000 --> 00:20:03,600 slow to write down the value of their investments, but equally 329 00:20:03,600 --> 00:20:06,480 in market rises they're slow to mark them up. 330 00:20:06,840 --> 00:20:10,280 Now, it shouldn't be hard to adjust the value of a portfolio 331 00:20:10,280 --> 00:20:14,520 of private assets in line with the overall stock market, as if 332 00:20:14,520 --> 00:20:17,920 you're levered long small cap equities and the stock market 333 00:20:17,920 --> 00:20:23,000 falls by 25%, your portfolio most likely fell by that amount 334 00:20:23,000 --> 00:20:26,120 or more. When people see the stock market 335 00:20:26,120 --> 00:20:30,000 fall and private equity funds claim that their investments are 336 00:20:30,000 --> 00:20:33,480 just fine, they might get the feeling that they have a low 337 00:20:33,480 --> 00:20:37,000 risk investment. But best of luck selling it at 338 00:20:37,000 --> 00:20:39,520 anything close to the price it's marked to. 339 00:20:39,800 --> 00:20:42,960 What you have instead is Schrodinger's investment 340 00:20:42,960 --> 00:20:47,400 returns. A 2002 paper by Mark Anson 341 00:20:47,680 --> 00:20:51,240 looked at the effect of stale pricing in the risk and return 342 00:20:51,240 --> 00:20:53,600 analysis of private equity investments. 343 00:20:53,880 --> 00:20:58,440 Managers reporting unnecessarily stale pricing, as described by 344 00:20:58,440 --> 00:21:02,480 Cliff Asness, can result in investors underestimating the 345 00:21:02,480 --> 00:21:06,280 risk of an investment and overestimating the manager's 346 00:21:06,280 --> 00:21:09,840 skill. Anson's paper demonstrated that 347 00:21:09,840 --> 00:21:13,680 there was a significant lagged beta effect for leveraged 348 00:21:13,680 --> 00:21:17,920 buyouts, venture capital, and mezzanine debt investments, and 349 00:21:17,920 --> 00:21:22,040 that the lagged market betas are statistically significant for up 350 00:21:22,040 --> 00:21:25,760 to four prior quarters of public stock market returns. 351 00:21:26,040 --> 00:21:29,960 Since betas are linearly additive, the sum of the lagged 352 00:21:29,960 --> 00:21:33,920 betas provides an estimate of the total systematic risk 353 00:21:33,960 --> 00:21:36,800 embedded within private equity portfolios. 354 00:21:37,200 --> 00:21:41,000 Hanson found that the systematic risk in private equity was 355 00:21:41,000 --> 00:21:44,280 approximately double what it first appeared to be. 356 00:21:44,760 --> 00:21:48,200 Now, I'm not trying to beat up on Tony Robbins here, but it 357 00:21:48,200 --> 00:21:52,160 would appear that his assessment of investment risk is almost as 358 00:21:52,160 --> 00:21:56,280 skewed as his assessment of the risk of walking over hot coals. 359 00:21:56,480 --> 00:21:59,720 And I'm basing that on a New York Times article which 360 00:21:59,720 --> 00:22:03,560 reported that 30 people had to be treated for burns after 361 00:22:03,560 --> 00:22:06,320 walking over hot coals at one of his seminars. 362 00:22:06,560 --> 00:22:10,320 His website site says walking over those hot coals is a 363 00:22:10,320 --> 00:22:14,480 symbolic experience that proves if you can make it through the 364 00:22:14,480 --> 00:22:17,000 fire, you can make it through anything. 365 00:22:17,360 --> 00:22:19,960 And I guess that's an interesting way of working out 366 00:22:20,040 --> 00:22:24,440 which of your seminar attendees can't make it through anything. 367 00:22:24,440 --> 00:22:28,000 All right, look, let's just cut through the old crap cake here, 368 00:22:28,840 --> 00:22:31,360 OK? The biggest problem in Tony's 369 00:22:31,360 --> 00:22:36,200 statement on CNBC is that even if he was right that returns had 370 00:22:36,200 --> 00:22:39,560 been higher and risk had been lower than public markets in the 371 00:22:39,560 --> 00:22:43,600 past, there's no reason to believe that an investor today 372 00:22:43,600 --> 00:22:47,280 will get the same returns. When you invest in a strategy, 373 00:22:47,400 --> 00:22:50,840 you get its future returns, not its past returns. 374 00:22:51,040 --> 00:22:54,440 If we follow Tony's approach to investing, we would put 375 00:22:54,440 --> 00:22:58,400 everything in Altria, a group which used to be known as Philip 376 00:22:58,400 --> 00:23:01,360 Morris. It's a tobacco company and was 377 00:23:01,360 --> 00:23:04,760 the highest returning stock of the last 100 years. 378 00:23:05,000 --> 00:23:10,160 A dollar invested 100 years ago would be worth $2.65 million 379 00:23:10,160 --> 00:23:13,600 today. Most of the returns of investing 380 00:23:13,600 --> 00:23:17,120 in private equity came when the private equity business was a 381 00:23:17,120 --> 00:23:21,520 lot smaller than it is today and under very different tax rules. 382 00:23:21,800 --> 00:23:25,920 Today, we have dozens of massive buyout funds all chasing the 383 00:23:25,920 --> 00:23:29,920 same deals, meaning that they are significantly less likely to 384 00:23:29,920 --> 00:23:33,600 find underpriced assets than they found years ago. 385 00:23:33,920 --> 00:23:38,920 The deal landscape today is nothing like it was in 1978 when 386 00:23:38,920 --> 00:23:44,440 KKR put up $1,000,000 is to buy a $380 million company. 387 00:23:44,840 --> 00:23:49,800 Today, private equity firms are sitting on $2.6 trillion of cash 388 00:23:49,800 --> 00:23:53,160 reserves looking for deals to do so. 389 00:23:53,160 --> 00:23:56,680 How did that 1978 deal work out anyhow? 390 00:23:56,960 --> 00:24:01,080 Well, once levered up, who day had to manage more for cash 391 00:24:01,080 --> 00:24:04,960 flows than for profits as they had those steep debt repayments 392 00:24:04,960 --> 00:24:08,640 to meet? A severe recession came in 1981 393 00:24:08,640 --> 00:24:13,480 to 1982, right as competition in making machine tools appeared 394 00:24:13,480 --> 00:24:17,000 from Japan. Firm management petitioned the 395 00:24:17,000 --> 00:24:20,720 government for protection from Japanese imports, but the 396 00:24:20,720 --> 00:24:23,960 request was denied. The company underwent a 397 00:24:23,960 --> 00:24:28,280 restructuring plan, spinning off a number of divisions to reduce 398 00:24:28,280 --> 00:24:30,680 debt. A year later, it underwent 399 00:24:30,680 --> 00:24:34,520 another LBO, or what might be more accurately called a 400 00:24:34,520 --> 00:24:38,000 recapitalization. The equity investors who paid 401 00:24:38,000 --> 00:24:44,800 $2.52 per share for their stock in 1979 received $11.00 per 402 00:24:44,800 --> 00:24:49,280 share seven years later. The recapitalization piled debt 403 00:24:49,320 --> 00:24:53,440 upon debt at the high interest rates of the time, and the firm 404 00:24:53,440 --> 00:24:56,920 was eventually broken up and sold off in pieces. 405 00:24:57,440 --> 00:25:01,640 One of the arguments in favor of investing in private equity is 406 00:25:01,640 --> 00:25:04,880 that the number of public companies available to invest in 407 00:25:04,880 --> 00:25:08,440 today has reached a new low, as start-ups have been staying 408 00:25:08,440 --> 00:25:12,200 private for much longer than in the past and equity issuance, 409 00:25:12,200 --> 00:25:17,320 net of stock buybacks, is today at its lowest level in 25 years. 410 00:25:17,600 --> 00:25:21,560 It can be argued that these trends are working together to 411 00:25:21,560 --> 00:25:24,480 limit investment opportunities communities for public market 412 00:25:24,480 --> 00:25:27,640 investors. Private equity can serve a 413 00:25:27,640 --> 00:25:30,400 valuable role in an institutional investors 414 00:25:30,400 --> 00:25:35,040 portfolio as it provides small cap equity exposure which is 415 00:25:35,040 --> 00:25:38,920 worthwhile having, and the additional leverage might appeal 416 00:25:38,920 --> 00:25:43,320 to institutional investors with a long investment time horizon. 417 00:25:43,560 --> 00:25:47,200 It's not obvious that retail investors should be stepping in 418 00:25:47,360 --> 00:25:50,680 when the research shows that they can get similar returns 419 00:25:50,680 --> 00:25:52,960 from a small cap equity index fund. 420 00:25:53,880 --> 00:25:57,280 Retail investors don't need to deploy the same amount of 421 00:25:57,280 --> 00:26:00,440 capital as sovereign wealth funds and pension funds do 422 00:26:00,440 --> 00:26:05,320 either. the FT recently wrote that if the mosaic of assets 423 00:26:05,320 --> 00:26:09,920 managed by KKR were folded into one entity and listed on the 424 00:26:09,920 --> 00:26:13,440 stock market, it's market cap would be comparable to 425 00:26:13,440 --> 00:26:17,280 industrial giants like GE, Lockheed Martin or three. 426 00:26:17,280 --> 00:26:21,520 MKKR now resembles the sprawling, diversified 427 00:26:21,520 --> 00:26:23,920 conglomerates. It wouldn't broke up. 428 00:26:24,600 --> 00:26:28,880 According to Pitch Book data, private equity's annual internal 429 00:26:28,880 --> 00:26:34,760 rate of return fell below 10% in the year to March 2024, and over 430 00:26:34,760 --> 00:26:39,760 the same period an investment in the S&P 500 returned 30%. 431 00:26:40,200 --> 00:26:43,440 A big reason for this underperformance is that private 432 00:26:43,440 --> 00:26:47,520 equity is a levered investment in small cap stocks with 433 00:26:47,520 --> 00:26:51,440 sufficient cash flows to pay down their debts, while recent 434 00:26:51,440 --> 00:26:55,240 stock market performance has been driven by mega cap tech 435 00:26:55,240 --> 00:26:58,560 firms, which private equity has no exposure to. 436 00:26:59,240 --> 00:27:03,840 According to a presentation by Aswat Demoterin at NYU, private 437 00:27:03,840 --> 00:27:07,200 equity firms typically buy companies that have suffered 438 00:27:07,200 --> 00:27:10,200 declining profits in the two years leading up to the 439 00:27:10,200 --> 00:27:14,520 acquisition, and profitability typically improves in the two 440 00:27:14,520 --> 00:27:18,960 years after acquisition. This improvement, he finds, is 441 00:27:18,960 --> 00:27:21,680 most pronounced when leverage is higher. 442 00:27:21,960 --> 00:27:25,760 The companies bought up have often under invested relative to 443 00:27:25,760 --> 00:27:28,600 their peers before the acquisition, and there is a 444 00:27:28,600 --> 00:27:31,920 decline in investment after the acquisition. 445 00:27:32,440 --> 00:27:37,000 Demotorin finds that private equity owned firms don't default 446 00:27:37,000 --> 00:27:41,160 more frequently than similarly levered, publicly listed firms. 447 00:27:41,600 --> 00:27:44,840 He finds that while private equity is often blamed for job 448 00:27:44,840 --> 00:27:48,400 losses, there's little evidence to support this claim. 449 00:27:48,720 --> 00:27:52,360 Research shows that while layoffs often do come after an 450 00:27:52,360 --> 00:27:56,440 acquisition, new jobs are also frequently created in new 451 00:27:56,440 --> 00:27:58,600 businesses that these firms enter. 452 00:27:59,200 --> 00:28:02,840 While people criticize private equity for exploiting the tax 453 00:28:02,840 --> 00:28:07,480 code, the tax shield associated with higher debt is available to 454 00:28:07,480 --> 00:28:11,320 every company, and if they're under taxed, the blame lies with 455 00:28:11,320 --> 00:28:14,880 the politicians who write the tax code, not the companies 456 00:28:14,880 --> 00:28:18,160 governed by it. If insufficient taxes are being 457 00:28:18,160 --> 00:28:22,080 collected, the government is able to change the tax code as 458 00:28:22,080 --> 00:28:26,480 they did in the 1980s. I don't invest in private equity 459 00:28:26,640 --> 00:28:30,320 and I don't intend to do so either, as I believe similar 460 00:28:30,320 --> 00:28:34,040 returns are available in public markets with better legal 461 00:28:34,040 --> 00:28:37,240 protections in place. I don't worry about missing the 462 00:28:37,240 --> 00:28:41,080 boat on this front either, as right now it would appear that 463 00:28:41,080 --> 00:28:44,880 there might be too much money chasing too few deals, and I 464 00:28:44,880 --> 00:28:48,800 don't expect to see huge returns out of these funds in the coming 465 00:28:48,800 --> 00:28:51,920 years. I don't have any objection to 466 00:28:51,920 --> 00:28:55,120 the industry either. I think that it's a net benefit 467 00:28:55,120 --> 00:28:58,800 to the economy to have people out there making changes at 468 00:28:58,800 --> 00:29:02,760 inefficiently run firms, and it strikes me that an economy 469 00:29:02,760 --> 00:29:06,560 made-up of stagnant, badly managed companies wouldn't 470 00:29:06,560 --> 00:29:09,520 provide more jobs or higher tax revenues. 471 00:29:09,760 --> 00:29:13,320 But feel free to disagree with me in the comments section. 472 00:29:13,800 --> 00:29:16,920 Thanks for tuning into this week's podcast, with special 473 00:29:16,920 --> 00:29:20,160 thanks to my supporters on Patreon where I sometimes 474 00:29:20,240 --> 00:29:22,160 sometimes release the videos early. 475 00:29:22,440 --> 00:29:24,680 Talk to you all again soon. Bye. 476 00:29:25,560 --> 00:29:29,000 If you enjoyed this episode, be sure to subscribe so you're 477 00:29:29,000 --> 00:29:30,960 notified when a new episode is posted. 478 00:29:31,400 --> 00:29:34,120 Thank you to everyone who is supporting this content on 479 00:29:34,120 --> 00:29:36,600 Patreon. If you enjoyed this content, you 480 00:29:36,600 --> 00:29:40,240 can find more like it on YouTube, on the Patrick Boyle on 481 00:29:40,240 --> 00:29:44,480 Finance channel, or follow us on Twitter at Patrick E Boyle. 482 00:29:44,800 --> 00:29:46,160 Thanks for listening. Bye. 483 00:29:50,240 --> 00:29:50,360 Yeah.