Hello and welcome. You are listening to Patrick
Boyle on Finance, a podcast exploring ideas from
quantitative finance, examining events occurring in markets
right now and financial history to see what lessons can be taken
away, including interviews with some of the most interesting
people in the world of finance. To learn more about the podcast,
visit on finance.org. A friend of mine sent me a link
last week to a CNBC interview with the giant motivational
speaker Tony Robbins, where he extolled the virtues of
investing in private equity. Robbins argued that private
equity provided high returns with low risk to rich investors
and that these great returns would soon become available to
ordinary investors and, surprisingly, with no fees.
In fact, I was confused as he seemed to be saying that you
would receive fees as an investor.
All of these rich idiots are paying fees, but somehow regular
people won't have to. I haven't watched CNBC in quite
some time, but the whole thing came off as being like a
commercial. For decades, you know, private
institutions, big institutions, pension funds, ultra wealthy
people have had access, but the general public has not had
access and most of them don't even understand the impact.
For example, in the S&P 500 for the last 35 years, we know we've
compounded at 9.2%. It's pretty darn good.
You're doubling your money about every eight years, but you've
got 14.2%. Not with these guys with average
private equity. So imagine getting 50% more per
year compounded for decades. So you don't have to fight to
get into these funds anymore. You can actually purchase the
fund, the companies themselves, you can become a general
partners. You know you're a limited
partner when you're an investor in one of these funds.
But you like the CEO, the CFO, and they make 2% when they make
you money or not, and they make 20% of the upside.
And people give that because the amazing returns.
Well, now you get the two and 20.
It's pretty extraordinary. So I own 65 different firms,
some of the biggest in the world now that I'm a partner in in
that area and anyone can start to do this.
Now, I know very little about Tony Robbins, but as you can
probably guess, I was instantly skeptical.
These claims fly in the face of all financial theory.
To start with, it's not obvious why investing in private
companies would provide much higher returns than investing in
publicly listed companies. Private companies are still just
businesses and subject to the business cycle like all
investments, and many of the private companies were even
taken private by investors paying a premium to the public
shareholders. It's really not obvious why a
privately held business would be less risky than a listed
business, or that an investor should expect to get higher
returns with lower risk. Now I did some Googling and I
have to tell you, I'm actually quite impressed by Tony Robbins.
He's made some big promises in the past, and at least in one
case, appears to have lived up to them.
More than 30 years ago, Tony Robbins wrote a book called
Awaken the Giant Within, and straight away I thought, well,
who can do that? And the answer is Tony Robbins.
It seems to He's 6 feet 7 inches tall, An actual giant.
There's no one better qualified to write a book like that.
In fact, I'll have to go out and buy one.
I realized that I probably shouldn't have been so
skeptical. Anyone with a basic knowledge of
history knows that giants like Tony Robbins probably have a
goose that lays golden eggs, and so maybe we should buy some of
his magic beans. It has to work out, right?
So first up, what is private equity?
Are the returns really as high as Tony Robbins says?
And is the risk as low on top of that?
When people say that private equity firms are evading taxes
and ruining the economy, are they right?
Well, private equity is quite simply investing in companies
that are not listed on a Stock Exchange.
Private equity funds can be broken down into venture
capital, which involves investing in startups, which are
high risk, high return growth capital, which involves taking a
minority stake in a mature company that either needs this
capital to grow or needs it to commercialize a new product
line. And finally, leveraged buyouts,
where the fund uses a large amount of debt to purchase an
entire company. In an LBO, the buyer usually
uses the company's assets as collateral for the debt and
plans to pay it off with the company's future cash flow.
We'll be focusing mostly on LB OS today, as that's what most
people mean when they talk about private equity.
And there's a long history of transactions like this as people
have been borrowing money to buy out businesses as long as
businesses have existed. J Pierpont Morgan's acquisition
of Carnegie Steel in 19 O1 for $480 million is considered the
first true major buyout. And the first leveraged buyout
was the purchase of PAN Atlantic Steamship Company and Waterman
Steamship by McLean Industries in 1955, where the buyer
borrowed $42 million for the transaction and were able to pay
off $20 million of that debt as soon as the transaction closed
using the cash and assets of the acquired companies.
Up until the 1980's, the LBO remained an obscure financing
technique as since the Great Depression companies had kept
their debt loads low. Robin Wigglesworth described in
the FT how KKR's 1978 purchase of Who Day Industries using only
$1 million in equity for the $380 million purchase was
private equity's genesis moment. The deal was structured such
that the target firm itself was responsible for repaying the
massive debt. This deal showed just how
ambitious even a small investment company could be and
became a blueprint for the industry.
Wigglesworth describes how the deal documents became widely
read on Wall Street by people like Stephen Schwarzman, then a
partner at Lehman Brothers. Schwarzman wrote in his book
King of Capital that he had read the deal prospectus, looked at
the capital structure, and realized the returns that could
be achieved. He described it as a Rosetta
Stone for how to do leverage buyouts.
Over the next decade, the LBO became the biggest business on
Wall Street. From the early 1960s through
until the late 1970s, American executives participated in a
wave of acquisitions where they built massive diversified
conglomerates. The ranks of middle management
at these firms grew and profitability began to decline
as the businesses became too unwieldy to manage.
Many of these businesses were trading at a discount to net
asset value and the early LB OS involved buying these businesses
up on the cheap and breaking them up by selling off the
pieces for something closer to fair value.
This breakup approach led to a media backlash against the greed
of these so-called corporate Raiders.
The character Gordon Gekko in the 1987 film Wall Street was
based on a number of high profile corporate Raiders of the
day and was supposed to be the villain of the film.
The writers were shocked when the public saw Gekko as a hero
rather than as a villain for his line.
Greed is good. So how did these deals work?
Well, while every deal is unique, the one common element
is financial leverage or borrowed money to complete the
transaction. Some portion of the debt
incurred in the LBO is secured by the assets of the acquired
business and its cash flows are used to service the buyer debt.
With an LBO, the acquired company helps pay for itself and
for this reason the deals were sometimes called bootstrap
acquisitions. The high level of debt helps the
private equity company to achieve acceptable returns for
their investors and maybe more importantly, provided tax
savings. Due to the tax deductibility of
interest expense, Private equity companies often encourage top
company management to invest alongside them in the deal,
better aligning management incentives with investors.
It's argued that the large interest and principal expenses
incurred put management under pressure to improve operating
efficiency, and that the discipline of debt can force
management to cut costs, divest non core businesses and invest
in technological upgrades to improve efficiency.
While private equity firms will be flexible in terms of what
they invest in, the leverage nature of their business means
that strong cash flow generation and a strong asset base will
matter a lot, as you can't really borrow without these
attractive valuations, along with relatively little existing
debt will matter too. One of the key drivers of
returns to early leverage buyouts was that not only did
expensing the interest payment on debt reduce the tax burden on
the acquired company, but what was known as the general
utilities doctrine meant that a buyer who bought at least 80% of
the stock of a corporation could treat the transaction for tax
purposes as liquidation of the corporation and purchase of its
assets. Corporations liquidating their
assets were not subject to capital gains tax on the
appreciation in value on their assets and what this meant was
that the value of assets could be written up and re
depreciated, reducing the taxes owed by the company.
These newly leveraged firms would have to pay little if any
corporate income tax for the life of the buyout.
This meant that no business turn around was even needed.
The same stream of corporate income now shielded from tax
could be used to service the massive debt taken on in the
transaction with the belief that the taxpayer was subsidizing
leverage buyouts. Ronald Reagan's Tax Reform Act
of 1986 repealed the general utility's doctrine, reducing the
profitability of these deals. We're reducing tax rates by
simplifying the complex system of special provisions that favor
some at the expense of others. Restoring confidence in our tax
system means restoring and respecting the principle of
fairness for all. We'll be back.
After a quick break. It's like our brains have a mind
of their own when it comes to money, right?
Yeah. It's crazy.
We're diving into that today, how our brains really deal with
money. We're going deep on this one,
looking at money and how we decide behavioral research.
This stuff is like eye opening. Seriously, it turns out our
brains aren't always rational, especially with money.
No kidding. So what's the deal with that?
Why are we so bad at making, you know, sensible financial
decisions? Well, our brains are kind of
lazy in a way. They love taking shortcuts.
OK. So who invests in private
equity? Tony Robbins told the CNBC
audience that regular people don't get a look in, It's just
the ultra wealthy. Well, when we look at the
biggest investors in private equity, it's a mix of pension
funds and sovereign wealth funds, which is basically the
money of ordinary people. Just over half of the money in
private equity comes from public pension funds, 1/4 comes from
sovereign wealth funds. Then we've got insurance
companies, foundations, private pension funds, banks and so on.
CPP, the Canadian Pension plan, is a huge allocator to private
equity, as is CalPERS, the Californian public pension plan.
Broken down by country, the US, Canada and Singapore are the
biggest allocators. So when Tony asks why do the
richest people in the world get the greatest assets, it's maybe
a bit misleading. If you invest in private equity,
you're getting to invest like a teacher or a firefighter, not
Jeff Bezos. If you want to invest like Jeff
Bezos, you have to put almost all of your money in Amazon, a
publicly listed stock. So what do the investment
returns look like then? Tony said the returns are 50%
higher than public equities, but that's not really accurate.
Firstly, private equity funds don't actually report total
returns like other fund managers do.
They report the funds IRR, or internal rate of return.
When an investor commits to invest in a private equity fund,
their money doesn't go in right away.
The first four to five years of a private equity fund's life are
known as the investment period. In this period, the fund usually
draws down committed capital to make investments into portfolio
companies. Although they usually call in
most of the committed capital during the first five years, it
can sometimes take them longer to invest at all, such as if
they feel there are no good investment opportunities.
Warren Buffett explained the problem with this at a
shareholder meeting in 2019, saying when you commit the money
to private equity firms, they don't take the money, but you
pay a fee on the money that you've committed.
You really have to have that money ready to come up with at
any time. And of course, it makes their
returns look better if you sit there for a long time in
Treasury bills, which you have to hold because they can call
you up and demand the money and and they don't count that in
their IRR calculations. There are other tricks, too.
The Wall Street Journal described in 2018 how the funds
often don't call the cash as soon as an investment is
identified, instead borrowing money to make the investment in
what's called a bridge loan, tapping investors for cash
later. According to the Journal, this
was originally done to make capital calls more predictable
for investors. But while the practice doesn't
boost a cash profits, it does decrease the time during which
investors cash is held in the fund, delaying the moment when
the clock starts ticking from an IR or calculation standpoint,
which can result in a significant boost in the
internal rate of return. So as impressive as reported IRS
often look, that's not the actual return that an investor
gets. Internal rate of return is quite
a problematic metric. It's a bit like yield to
maturity on a bond where there's a built in reinvestment
assumption which may not play out in real life as the amount
of capital invested changes over time.
It's not very easy to know average private equity returns
as the funds themselves don't report returns to a central
database, and the series of returns that people analyse
contains survivorship bias. When people claim that private
equity outperforms public equities by 3% a year.
A big problem with that number is that most of that
outperformance happened 20 or more years ago when the industry
was much smaller and there was more low hanging fruit.
Over the last 20 years, the outperformance has been closer
to 1% a year after fees, which while not as impressive, is
still good and should compound out into significantly greater
wealth for investors over time. Sadly, using pitch book data, it
would appear that private equity stopped outperforming the S&P
515 years ago and over the last year significantly
underperformed the stock market. A 2014 paper from Oxford
University made the argument that investors had been using
the wrong benchmark, the MSCI All Country World Index, to
judge private equity returns, as that index has a weighting of
about 50% for U.S. stocks and private equity funds invest
about 80% of their money in the United States, which has
outperformed international stocks over that period.
Additionally, private equity typically invests in smaller
companies than are in the big US indices.
And most importantly, public equities use considerably less
leverage than the companies in a leveraged buyout fund.
The paper argued that you could not judge private equity returns
without taking these factors into account.
The author concluded that if the benchmark is changed to small
and value indices and is levered up, the average buy out fund
underperforms by three-point 1% per annum.
And that's not what we're trying to do at all.
How are we going to awaken the giant within if we're growing
3.1% less than our benchmark? Building on this research, a
paper in the Financial Analyst Journal dug even deeper.
The authors used a more complete database of returns and
conducted a thorough bottom up analysis of the risk
characteristics of the underlying companies in buyout
funds. This paper found that the
underlying companies that buyout funds invest in have on average
smaller market caps than their public counterparts.
Their sector composition is materially different to big US
indices, for example, significantly overweight
consumer discretionary stocks and underweight the financial
sector and their leverage is much higher than that of public
companies in the same sector. When they adjusted for size,
sector composition and leverage of portfolio companies in buyout
funds, the outperformance was reduced by more than half.
Finally, when they adjusted for the vintage of the funds, they
found no evidence of private equity outperformance.
That then leads us to Tony Robbins argument that private
equity is low risk. If the returns are the same as
the returns of a leveraged investment in small cap stocks
because the funds make levered investments in small cap stocks,
then an investment in private equity should be riskier than
the average portfolio. One risk that you're taking when
investing in private equity is that your investment is
illiquid, meaning that you can't necessarily get your money back
quickly if you want it. Now, normally when an investor
takes an incremental risk like this, they expect to get an
incremental return in compensation.
It doesn't appear that with private equity investors are
being compensated for the illiquidity risk that they're
taking. This leads us to Cliff Osnes
argument that private equity investors and fund managers are
playing a dangerous game of what he calls volatility laundering.
Asness argues that the illiquidity of private equity
and the fact that the assets are held at prices that in no way
relate to real world asset values was historically
acknowledged in the industry as a bug, but today this bug is
being sold to investors as a feature.
He points out that investors usually get paid to accept a
bug, but are expected to pay up to receive a feature in market
sell offs. Private equity funds are very
slow to write down the value of their investments, but equally
in market rises they're slow to mark them up.
Now, it shouldn't be hard to adjust the value of a portfolio
of private assets in line with the overall stock market, as if
you're levered long small cap equities and the stock market
falls by 25%, your portfolio most likely fell by that amount
or more. When people see the stock market
fall and private equity funds claim that their investments are
just fine, they might get the feeling that they have a low
risk investment. But best of luck selling it at
anything close to the price it's marked to.
What you have instead is Schrodinger's investment
returns. A 2002 paper by Mark Anson
looked at the effect of stale pricing in the risk and return
analysis of private equity investments.
Managers reporting unnecessarily stale pricing, as described by
Cliff Asness, can result in investors underestimating the
risk of an investment and overestimating the manager's
skill. Anson's paper demonstrated that
there was a significant lagged beta effect for leveraged
buyouts, venture capital, and mezzanine debt investments, and
that the lagged market betas are statistically significant for up
to four prior quarters of public stock market returns.
Since betas are linearly additive, the sum of the lagged
betas provides an estimate of the total systematic risk
embedded within private equity portfolios.
Hanson found that the systematic risk in private equity was
approximately double what it first appeared to be.
Now, I'm not trying to beat up on Tony Robbins here, but it
would appear that his assessment of investment risk is almost as
skewed as his assessment of the risk of walking over hot coals.
And I'm basing that on a New York Times article which
reported that 30 people had to be treated for burns after
walking over hot coals at one of his seminars.
His website site says walking over those hot coals is a
symbolic experience that proves if you can make it through the
fire, you can make it through anything.
And I guess that's an interesting way of working out
which of your seminar attendees can't make it through anything.
All right, look, let's just cut through the old crap cake here,
OK? The biggest problem in Tony's
statement on CNBC is that even if he was right that returns had
been higher and risk had been lower than public markets in the
past, there's no reason to believe that an investor today
will get the same returns. When you invest in a strategy,
you get its future returns, not its past returns.
If we follow Tony's approach to investing, we would put
everything in Altria, a group which used to be known as Philip
Morris. It's a tobacco company and was
the highest returning stock of the last 100 years.
A dollar invested 100 years ago would be worth $2.65 million
today. Most of the returns of investing
in private equity came when the private equity business was a
lot smaller than it is today and under very different tax rules.
Today, we have dozens of massive buyout funds all chasing the
same deals, meaning that they are significantly less likely to
find underpriced assets than they found years ago.
The deal landscape today is nothing like it was in 1978 when
KKR put up $1,000,000 is to buy a $380 million company.
Today, private equity firms are sitting on $2.6 trillion of cash
reserves looking for deals to do so.
How did that 1978 deal work out anyhow?
Well, once levered up, who day had to manage more for cash
flows than for profits as they had those steep debt repayments
to meet? A severe recession came in 1981
to 1982, right as competition in making machine tools appeared
from Japan. Firm management petitioned the
government for protection from Japanese imports, but the
request was denied. The company underwent a
restructuring plan, spinning off a number of divisions to reduce
debt. A year later, it underwent
another LBO, or what might be more accurately called a
recapitalization. The equity investors who paid
$2.52 per share for their stock in 1979 received $11.00 per
share seven years later. The recapitalization piled debt
upon debt at the high interest rates of the time, and the firm
was eventually broken up and sold off in pieces.
One of the arguments in favor of investing in private equity is
that the number of public companies available to invest in
today has reached a new low, as start-ups have been staying
private for much longer than in the past and equity issuance,
net of stock buybacks, is today at its lowest level in 25 years.
It can be argued that these trends are working together to
limit investment opportunities communities for public market
investors. Private equity can serve a
valuable role in an institutional investors
portfolio as it provides small cap equity exposure which is
worthwhile having, and the additional leverage might appeal
to institutional investors with a long investment time horizon.
It's not obvious that retail investors should be stepping in
when the research shows that they can get similar returns
from a small cap equity index fund.
Retail investors don't need to deploy the same amount of
capital as sovereign wealth funds and pension funds do
either. the FT recently wrote that if the mosaic of assets
managed by KKR were folded into one entity and listed on the
stock market, it's market cap would be comparable to
industrial giants like GE, Lockheed Martin or three.
MKKR now resembles the sprawling, diversified
conglomerates. It wouldn't broke up.
According to Pitch Book data, private equity's annual internal
rate of return fell below 10% in the year to March 2024, and over
the same period an investment in the S&P 500 returned 30%.
A big reason for this underperformance is that private
equity is a levered investment in small cap stocks with
sufficient cash flows to pay down their debts, while recent
stock market performance has been driven by mega cap tech
firms, which private equity has no exposure to.
According to a presentation by Aswat Demoterin at NYU, private
equity firms typically buy companies that have suffered
declining profits in the two years leading up to the
acquisition, and profitability typically improves in the two
years after acquisition. This improvement, he finds, is
most pronounced when leverage is higher.
The companies bought up have often under invested relative to
their peers before the acquisition, and there is a
decline in investment after the acquisition.
Demotorin finds that private equity owned firms don't default
more frequently than similarly levered, publicly listed firms.
He finds that while private equity is often blamed for job
losses, there's little evidence to support this claim.
Research shows that while layoffs often do come after an
acquisition, new jobs are also frequently created in new
businesses that these firms enter.
While people criticize private equity for exploiting the tax
code, the tax shield associated with higher debt is available to
every company, and if they're under taxed, the blame lies with
the politicians who write the tax code, not the companies
governed by it. If insufficient taxes are being
collected, the government is able to change the tax code as
they did in the 1980s. I don't invest in private equity
and I don't intend to do so either, as I believe similar
returns are available in public markets with better legal
protections in place. I don't worry about missing the
boat on this front either, as right now it would appear that
there might be too much money chasing too few deals, and I
don't expect to see huge returns out of these funds in the coming
years. I don't have any objection to
the industry either. I think that it's a net benefit
to the economy to have people out there making changes at
inefficiently run firms, and it strikes me that an economy
made-up of stagnant, badly managed companies wouldn't
provide more jobs or higher tax revenues.
But feel free to disagree with me in the comments section.
Thanks for tuning into this week's podcast, with special
thanks to my supporters on Patreon where I sometimes
sometimes release the videos early.
Talk to you all again soon. Bye.
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Thanks for listening. Bye.
Yeah.