1 00:00:00,040 --> 00:00:03,400 This August, President Trump signed an executive order 2 00:00:03,400 --> 00:00:08,119 allowing private equity firms to tap into America's 4O1K system. 3 00:00:08,400 --> 00:00:12,080 The stated goal was to democratize access, to stop 4 00:00:12,080 --> 00:00:15,920 babying smaller investors, and to let them play in the same 5 00:00:15,920 --> 00:00:19,760 sandbox as pension funds and sovereign wealth fund managers. 6 00:00:20,040 --> 00:00:23,760 Nothing says democratization like handing your retirement 7 00:00:23,760 --> 00:00:27,160 savings to Apollo. So why are the shares of 8 00:00:27,160 --> 00:00:30,520 publicly listed private equity firms underperforming the 9 00:00:30,520 --> 00:00:33,000 broader stock market so badly this year? 10 00:00:33,240 --> 00:00:38,760 You'd expect a rally instead. The GLPE index is down nearly 11 00:00:38,760 --> 00:00:42,960 10% year to date, and it's even down slightly since the 12 00:00:42,960 --> 00:00:47,840 announcement in early August. Apollo and Blue Owl are off more 13 00:00:47,840 --> 00:00:53,600 than 20% year to date. KKR, Aries, and TPG are all in 14 00:00:53,600 --> 00:00:57,480 double digit decline. Blackstone is down too, with 15 00:00:57,480 --> 00:01:01,960 Carlisle and Three I being outliers up more than the S&P. 16 00:01:02,360 --> 00:01:06,280 It turns out that letting retail investors into the sandbox 17 00:01:06,520 --> 00:01:10,800 doesn't necessarily help if the sandbox is full of broken toys. 18 00:01:11,560 --> 00:01:14,480 The Wall Street Journal points out that some of the 19 00:01:14,480 --> 00:01:18,320 underperformance might reflect an overhang from the run up in 20 00:01:18,320 --> 00:01:22,120 stock prices over the last few years, especially for some of 21 00:01:22,120 --> 00:01:26,120 the big firms who rallied ahead of being included in the S&P 22 00:01:26,120 --> 00:01:28,640 500. But there's still concerns 23 00:01:28,640 --> 00:01:32,040 hanging over the industry. Private equity firms are 24 00:01:32,040 --> 00:01:35,080 struggling to sell prior investments at attractive 25 00:01:35,080 --> 00:01:38,920 prices, and without exits, there are no distributions. 26 00:01:39,080 --> 00:01:42,920 Without distributions, it's much harder to raise new capital. 27 00:01:43,560 --> 00:01:47,640 Private equity is still sitting on trillions in assets, but the 28 00:01:47,640 --> 00:01:52,640 flywheel, raise, deploy, exit, distribute and repeat isn't 29 00:01:52,640 --> 00:01:56,360 spinning the way it used to. And the push into four O 1 KS 30 00:01:56,560 --> 00:02:00,600 looks maybe less like innovation and more like a search for new 31 00:02:00,600 --> 00:02:04,200 investors when the existing ones are getting frustrated. 32 00:02:04,960 --> 00:02:09,400 The S&P 500 is up around 14% this year if we include 33 00:02:09,400 --> 00:02:12,160 dividends. But it hasn't been a broad based 34 00:02:12,160 --> 00:02:13,840 rally. The returns have been 35 00:02:13,840 --> 00:02:18,240 concentrated in a handful of tech giants, the Magnificent 7 36 00:02:18,400 --> 00:02:22,840 minus Tesla, plus Broadcom, which make up more than 1/3 of 37 00:02:22,840 --> 00:02:25,720 the index. These firms are growing 38 00:02:25,720 --> 00:02:29,560 earnings, throwing off cash and doing it with less leverage than 39 00:02:29,560 --> 00:02:33,160 their predecessors. In the.com era, investors have 40 00:02:33,160 --> 00:02:36,400 been paying up for profitability and the market has been 41 00:02:36,400 --> 00:02:40,160 rewarding them. Private equity doesn't own any 42 00:02:40,160 --> 00:02:43,560 of these companies, and it doesn't own anything like them 43 00:02:43,680 --> 00:02:46,520 either. PE firms tend to own smaller 44 00:02:46,520 --> 00:02:50,720 businesses, often in slower growing sectors and usually with 45 00:02:50,720 --> 00:02:54,040 a lot more debt. The typical buyout fund is a 46 00:02:54,040 --> 00:02:58,600 leveraged bet on small cap value stocks, the exact corner of the 47 00:02:58,600 --> 00:03:02,640 market that's been lagging. It's not unreasonable to expect 48 00:03:02,640 --> 00:03:06,360 private equity returns to rise and fall with the broader stock 49 00:03:06,360 --> 00:03:09,280 market, adjusted for the additional leverage. 50 00:03:09,560 --> 00:03:12,720 But that relationship breaks down when the market is being 51 00:03:12,720 --> 00:03:16,840 driven by a narrow set of mega cap tech stocks that private 52 00:03:16,840 --> 00:03:19,280 equity funds have no exposure to. 53 00:03:19,920 --> 00:03:24,280 The IPO market has been dead for quite a while, and the kinds of 54 00:03:24,280 --> 00:03:28,280 companies sitting in private equity portfolios simply aren't 55 00:03:28,280 --> 00:03:31,160 what public investors are looking to invest in. 56 00:03:31,400 --> 00:03:35,040 Investors are not interested in paying top dollar for slow 57 00:03:35,040 --> 00:03:38,920 growth businesses with heavy debt loads, and that's making it 58 00:03:38,920 --> 00:03:42,280 much harder for PE firms to exit cleanly. 59 00:03:42,600 --> 00:03:47,200 Benchmarking private equity against the S&P 500 has always 60 00:03:47,200 --> 00:03:50,520 been a bit of a stretch. The sector invests mostly in 61 00:03:50,560 --> 00:03:54,080 U.S. companies, but they're smaller, more cyclical, and more 62 00:03:54,080 --> 00:03:56,960 heavily levered. A better comparison might be a 63 00:03:56,960 --> 00:04:01,200 basket of small cap value stocks with a few turns of debt layered 64 00:04:01,200 --> 00:04:03,640 on top, but even that's generous. 65 00:04:03,800 --> 00:04:08,240 Most small cap value ETFs don't charge fees of 2 and 20. 66 00:04:09,160 --> 00:04:12,360 Private equity is often described as being an asset 67 00:04:12,360 --> 00:04:14,800 class, but it's really just a structure. 68 00:04:14,960 --> 00:04:18,399 Most of the capital is deployed through buyout funds, which 69 00:04:18,399 --> 00:04:22,560 acquire controlling stakes in private companies using a mix of 70 00:04:22,560 --> 00:04:26,600 equity and debt, the debt does most of the heavy lifting. 71 00:04:26,880 --> 00:04:31,920 A typical deal might be financed with 60 to 75% leverage, far 72 00:04:31,920 --> 00:04:35,000 more than you'd find in a publicly listed company where 73 00:04:35,000 --> 00:04:38,640 debt to equity ratios tend to hover around 30%. 74 00:04:38,880 --> 00:04:41,920 The idea behind private equity is simple. 75 00:04:42,080 --> 00:04:46,280 Borrow heavily, buy a business, improve it or at least manage it 76 00:04:46,280 --> 00:04:50,080 somewhat efficiently, and then try to sell it later for more 77 00:04:50,080 --> 00:04:53,120 than you paid. The returns are supposed to come 78 00:04:53,240 --> 00:04:57,560 from operational improvements, multiple expansion, and most 79 00:04:57,560 --> 00:05:00,960 reliably leverage. The people picking the companies 80 00:05:00,960 --> 00:05:04,280 to buy often have backgrounds in investment banking or 81 00:05:04,280 --> 00:05:06,880 consulting. Whether that qualifies them to 82 00:05:06,880 --> 00:05:10,360 run a plumbing supply company, and whether they can run it 83 00:05:10,360 --> 00:05:13,880 better than its founder did is a separate question. 84 00:05:13,880 --> 00:05:17,400 But hey, if you can model A leveraged buyout in Excel, how 85 00:05:17,400 --> 00:05:21,360 hard can toilets be? Private equity funds tend to 86 00:05:21,360 --> 00:05:25,000 concentrate their bets in smaller companies, often in 87 00:05:25,000 --> 00:05:28,880 mature industries. The reason being that steady, if 88 00:05:28,880 --> 00:05:32,600 boring business models are much easier to borrow against. 89 00:05:32,800 --> 00:05:36,560 No one wants to lend money to a business with negative or even 90 00:05:36,560 --> 00:05:40,880 highly variable cash flows. That gives them exposure to the 91 00:05:40,880 --> 00:05:44,760 small cap and value factors tracked by academic finance. 92 00:05:44,960 --> 00:05:48,880 Historically, these factors outperformed, but that hasn't 93 00:05:48,880 --> 00:05:50,800 happened for quite some time now. 94 00:05:51,240 --> 00:05:55,280 PE funds also claim to offer access to the illiquidity 95 00:05:55,280 --> 00:05:58,240 premium. The idea is that buying hard to 96 00:05:58,240 --> 00:06:02,280 sell assets at a discount and locking up investor capital for 97 00:06:02,280 --> 00:06:05,800 years should result in higher long term returns. 98 00:06:06,080 --> 00:06:09,480 Whether that premium exists or not is debatable. 99 00:06:09,760 --> 00:06:13,000 What's clear is that the fees are high, the leverage is 100 00:06:13,000 --> 00:06:15,880 substantial and the exit routes are narrow. 101 00:06:16,400 --> 00:06:19,200 Private equity firms like to tell a story. 102 00:06:19,320 --> 00:06:22,320 It's it's a story about transformation, of taking 103 00:06:22,320 --> 00:06:25,720 sleepy, underperforming companies and turning them into 104 00:06:25,720 --> 00:06:28,240 lean, efficient, high growth machines. 105 00:06:28,480 --> 00:06:31,680 The protagonists are former investment bankers and 106 00:06:31,680 --> 00:06:34,960 consultants who, armed with spreadsheets and strategic 107 00:06:34,960 --> 00:06:39,160 vision, unlock hidden value through operational excellence. 108 00:06:39,440 --> 00:06:44,320 This is the myth of operational alpha, but the numbers tell a 109 00:06:44,320 --> 00:06:48,080 somewhat different story. Most of the returns in private 110 00:06:48,080 --> 00:06:52,480 equity come not from operational improvements, but from leverage. 111 00:06:52,680 --> 00:06:56,680 A typical buyout is financed with 60 to 75% debt, 112 00:06:56,800 --> 00:07:00,160 significantly more than the average for public companies. 113 00:07:00,520 --> 00:07:04,640 That leverage amplifies returns when things go well, but it also 114 00:07:04,640 --> 00:07:08,280 introduces fragility. But that part of the story is 115 00:07:08,280 --> 00:07:10,280 usually left out of the pitch deck. 116 00:07:10,800 --> 00:07:14,600 The idea that private equity managers are uniquely skilled at 117 00:07:14,600 --> 00:07:18,720 running businesses is hard to square with the resumes of many 118 00:07:18,720 --> 00:07:21,920 of the general partners. These are usually people with 119 00:07:21,920 --> 00:07:24,640 backgrounds in M&A, not manufacturing. 120 00:07:24,880 --> 00:07:28,080 They know how to structure a deal, but next to nothing about 121 00:07:28,080 --> 00:07:30,520 how to run a plumbing supply company. 122 00:07:30,760 --> 00:07:33,720 The founder that they're replacing, usually with a junior 123 00:07:33,720 --> 00:07:37,040 banker, may have spent 30 years building the business in 124 00:07:37,040 --> 00:07:39,720 question. The new owners have a five year 125 00:07:39,720 --> 00:07:43,720 exit horizon, the ability to borrow huge sums of money, and a 126 00:07:43,720 --> 00:07:46,280 model that assumes margin expansion. 127 00:07:46,680 --> 00:07:50,160 You might be surprised to hear that margin expansion rarely 128 00:07:50,160 --> 00:07:53,800 materializes. Bain's 2025 Global Private 129 00:07:53,800 --> 00:07:57,880 Equity Report shows that in the software business that they buy 130 00:07:57,880 --> 00:08:01,920 out, margin growth has contributed just 6% to value 131 00:08:01,920 --> 00:08:05,800 creation over the last decade. The rest of the return came from 132 00:08:05,800 --> 00:08:09,400 revenue growth and multiple expansion in carve outs 133 00:08:09,400 --> 00:08:11,600 transactions. Where a private equity firm 134 00:08:11,600 --> 00:08:15,400 acquires a non core division or subsidiary from a larger 135 00:08:15,400 --> 00:08:17,720 corporation, the story is similar. 136 00:08:17,880 --> 00:08:22,200 Pre 2012, sponsors boosted margins by 29%. 137 00:08:22,400 --> 00:08:26,000 Since then, that figure has fallen to 2%. 138 00:08:26,440 --> 00:08:29,680 Even when operational improvements are real, they're 139 00:08:29,680 --> 00:08:33,400 often overstated. As the CFA Institute and others 140 00:08:33,400 --> 00:08:37,480 have pointed out, the industry's preferred performance metric 141 00:08:37,559 --> 00:08:42,559 since inception, IRR, is highly sensitive to the timing of cash 142 00:08:42,559 --> 00:08:46,040 flows and can be gained through subscription lines and bridge 143 00:08:46,040 --> 00:08:48,880 loans. It's not a rate of return in any 144 00:08:48,880 --> 00:08:52,200 meaningful sense. It's a marketing number or the 145 00:08:52,200 --> 00:08:55,080 financial equivalent of Instagram filters. 146 00:08:55,200 --> 00:08:58,480 Flattering, but of nothing like reality. 147 00:08:58,880 --> 00:09:01,920 Warren Buffett has long criticized the private equity 148 00:09:01,920 --> 00:09:05,800 model for this reason. At Berkshire Hathaway's 2019 149 00:09:05,800 --> 00:09:10,320 meeting, he noted that investors in PE funds must hold cash on 150 00:09:10,320 --> 00:09:12,440 the sidelines ready to be called. 151 00:09:12,720 --> 00:09:16,760 That cash earns very little, especially during the 0 interest 152 00:09:16,760 --> 00:09:20,200 rate environment of the time, but that doesn't show up in the 153 00:09:20,440 --> 00:09:23,240 IRR. The result is a flattering 154 00:09:23,240 --> 00:09:27,200 returns number that ignores the real world cost of of capital. 155 00:09:27,720 --> 00:09:31,120 None of this is to say that private equity firms never 156 00:09:31,120 --> 00:09:33,160 improve the businesses that they buy. 157 00:09:33,360 --> 00:09:36,120 Some do. But the industry's aggregate 158 00:09:36,120 --> 00:09:39,840 returns, especially in recent years, suggests that operational 159 00:09:39,840 --> 00:09:42,560 alpha is more aspiration than reality. 160 00:09:42,760 --> 00:09:46,280 The real engine of private equity is just leverage, and in 161 00:09:46,280 --> 00:09:49,480 a world of higher interest rates, that engine is starting 162 00:09:49,480 --> 00:09:52,240 to sputter. Private equity has long sold 163 00:09:52,240 --> 00:09:56,360 itself as a source of stability. In a world of whipsawing public 164 00:09:56,520 --> 00:10:00,400 markets, private equity appears to offer smooth, upward, sloping 165 00:10:00,440 --> 00:10:02,800 returns. The lines on the performance 166 00:10:02,800 --> 00:10:07,400 charts are reassuringly linear. But as Cliff asness of AQ, or 167 00:10:07,400 --> 00:10:10,080 famously put it, this isn't stability. 168 00:10:10,080 --> 00:10:14,240 It's just stale pricing. The smoothing of returns in 169 00:10:14,240 --> 00:10:16,880 private equity is by no means a bug. 170 00:10:16,920 --> 00:10:20,600 It's a feature, and for quite some time has been a major 171 00:10:20,600 --> 00:10:23,400 selling point. Because private assets aren't 172 00:10:23,400 --> 00:10:26,680 marked to market, their prices don't fluctuate with daily 173 00:10:26,680 --> 00:10:30,280 headlines or quarterly earnings like publicly listed stocks do. 174 00:10:30,520 --> 00:10:34,000 Instead, they're occasionally appraised, often by the fund 175 00:10:34,000 --> 00:10:37,720 managers themselves or by third parties hired by the fund 176 00:10:37,720 --> 00:10:40,720 managers. This creates the illusion of low 177 00:10:40,720 --> 00:10:43,880 volatility. I remember speaking to a private 178 00:10:43,880 --> 00:10:47,560 equity fund manager during the credit crunch many years ago who 179 00:10:47,560 --> 00:10:50,840 claimed that while every asset in the world had collapsed in 180 00:10:50,840 --> 00:10:55,240 value, none of his portfolio companies had even ticked down. 181 00:10:55,560 --> 00:10:59,680 The fact that these investments conceal their true volatility is 182 00:10:59,680 --> 00:11:03,520 actually appealing to institutional investors bound by 183 00:11:03,520 --> 00:11:07,680 solvency rules or performance metrics that penalize draw 184 00:11:07,680 --> 00:11:11,000 downs. This illusion, however, comes at 185 00:11:11,000 --> 00:11:13,320 a cost. As an article on the CFA 186 00:11:13,320 --> 00:11:17,400 Institute website argues, the industry's reliance on, since 187 00:11:17,400 --> 00:11:20,760 inception internal rate of return as a performance metric 188 00:11:20,920 --> 00:11:25,280 is deeply misleading. IRR is not a rate of return in 189 00:11:25,280 --> 00:11:29,000 any meaningful economic sense, in that it's not a return that 190 00:11:29,000 --> 00:11:31,720 any private equity investor receives. 191 00:11:31,920 --> 00:11:35,360 It's more of a mathematical artifact, highly sensitive to 192 00:11:35,360 --> 00:11:38,920 the timing of cash flows and easily manipulated through 193 00:11:39,080 --> 00:11:42,240 subscription lines, bridge loans, and delayed capital 194 00:11:42,240 --> 00:11:45,280 calls. Consider a common tactic. 195 00:11:45,480 --> 00:11:49,400 A fund identifies a deal but delays calling capital from 196 00:11:49,400 --> 00:11:51,960 investors. Instead they use a short term 197 00:11:51,960 --> 00:11:56,200 loan to finance the acquisition. This shortens the measured 198 00:11:56,200 --> 00:11:59,240 holding period and inflates the IRR. 199 00:11:59,480 --> 00:12:02,800 Even though the underlying economics haven't changed, the 200 00:12:02,800 --> 00:12:07,440 fund looks like it's delivering a 25% return when in reality the 201 00:12:07,440 --> 00:12:10,760 investors actual return and accounting for idle cash and 202 00:12:10,760 --> 00:12:14,720 fees might be closer to 10%. The investors money has been 203 00:12:14,720 --> 00:12:18,360 sitting in bonds waiting for the capital call and instead of 204 00:12:18,360 --> 00:12:21,520 taking it the fund borrows money, often at a higher 205 00:12:21,520 --> 00:12:25,440 interest rate just so they can show an artificially inflated 206 00:12:25,640 --> 00:12:28,280 IRR. Then we have the proliferation 207 00:12:28,280 --> 00:12:31,720 of continuation funds. These are vehicles that allow 208 00:12:31,760 --> 00:12:35,720 APE Firm to sell an asset from one of its funds to another 209 00:12:35,720 --> 00:12:38,760 fund. It also manages and charges fees 210 00:12:38,760 --> 00:12:43,200 on the transaction, resets the clock, generates a paper gain in 211 00:12:43,200 --> 00:12:47,160 the first fund, creating the appearance of a successful exit. 212 00:12:47,680 --> 00:12:51,400 But the ACID hasn't changed hands in any meaningful way. 213 00:12:51,600 --> 00:12:54,480 It's a bit like selling your house to yourself at a higher 214 00:12:54,480 --> 00:12:59,720 price and declaring a profit. The Bain 2025 report notes that 215 00:12:59,720 --> 00:13:04,160 nearly 30% of companies in buyout portfolios have undergone 216 00:13:04,160 --> 00:13:08,160 some form of liquidity event, including secondaries, dividend 217 00:13:08,160 --> 00:13:11,480 recaps, and NAV loans without a true exit. 218 00:13:11,800 --> 00:13:14,720 These financial maneuvers generate cash flow and 219 00:13:14,720 --> 00:13:18,480 flattering metrics, but they don't necessarily reflect real 220 00:13:18,480 --> 00:13:21,880 value creation. This chart from Bloomberg shows 221 00:13:22,040 --> 00:13:25,520 that over the last few years the business is held on to in 222 00:13:25,520 --> 00:13:28,520 continuation. Funds are transferred at higher 223 00:13:28,520 --> 00:13:32,160 valuations than the ones actually exited from through 224 00:13:32,160 --> 00:13:35,720 sales. Investors are starting to notice 225 00:13:35,720 --> 00:13:38,560 this. Distributions to paid in capital 226 00:13:38,600 --> 00:13:43,360 DPIA, more grounded measure of actual cash returned, has become 227 00:13:43,360 --> 00:13:47,160 the metric of choice for many limited partners, and by that 228 00:13:47,160 --> 00:13:50,440 measure, the recent performance is underwhelming. 229 00:13:50,680 --> 00:13:55,840 Funds launched in 2019 are only just breaking even, and some may 230 00:13:55,840 --> 00:13:59,040 never get there. The smoothing of returns may 231 00:13:59,040 --> 00:14:02,960 help investors sleep at night, but it also obscures risk, 232 00:14:03,080 --> 00:14:06,880 conceals under performance, and makes it harder to distinguish 233 00:14:06,880 --> 00:14:10,240 skill from luck. In the end, Volatility 234 00:14:10,240 --> 00:14:13,440 laundering, as this technique has been named by Cliff Asness 235 00:14:13,440 --> 00:14:16,520 at AQR, is just that, laundering. 236 00:14:16,720 --> 00:14:19,240 In the end, it's not true stability. 237 00:14:19,240 --> 00:14:22,240 It's opacity dressed up as sophistication. 238 00:14:22,680 --> 00:14:26,800 Private equities promise of smooth returns is now colliding 239 00:14:26,800 --> 00:14:30,240 with a hard reality. The industry is struggling to 240 00:14:30,240 --> 00:14:33,080 convert paper gains into actual cash. 241 00:14:33,360 --> 00:14:39,000 The backlog of unsold companies now exceeds $3.6 trillion across 242 00:14:39,000 --> 00:14:43,920 nearly 30,000 portfolio firms. Distributions have slowed to a 243 00:14:43,920 --> 00:14:46,760 crawl. Bain's report shows the 244 00:14:46,760 --> 00:14:51,080 distributions as a percentage of net asset value have fallen to 245 00:14:51,080 --> 00:14:54,760 11%, the lowest rate in over a decade. 246 00:14:55,080 --> 00:14:59,440 The IPO market is comatose. Strategic buyers are cautious 247 00:14:59,600 --> 00:15:03,560 and sponsor to sponsor deals once a reliable exit route are 248 00:15:03,560 --> 00:15:07,600 now viewed with suspicion. Continuation funds, secondaries 249 00:15:07,720 --> 00:15:11,320 and NAV loans have stepped in to provide liquidity, but they're 250 00:15:11,320 --> 00:15:14,480 more account maneuvers than genuine exits. 251 00:15:15,000 --> 00:15:18,920 Liquidity challenges are also distorting valuations. 252 00:15:19,120 --> 00:15:22,320 When assets are never actually sold, you have to start 253 00:15:22,320 --> 00:15:24,440 wondering about their carrying value. 254 00:15:24,720 --> 00:15:29,640 Secondary market discounts, often 15% or more, reveal what 255 00:15:29,640 --> 00:15:32,360 investors really think these assets are worth. 256 00:15:32,600 --> 00:15:36,120 And that's before accounting for fees, leverage, and the time 257 00:15:36,120 --> 00:15:39,080 value of money. The collapse of First Brands, 258 00:15:39,080 --> 00:15:42,520 which I covered a few weeks ago and which is becoming a bigger 259 00:15:42,520 --> 00:15:46,160 and bigger story, illustrates the fragility of the system. 260 00:15:46,480 --> 00:15:50,040 First Brands borrowed heavily, pledged the same collateral 261 00:15:50,040 --> 00:15:53,960 multiple times, and relied on opaque invoice financing 262 00:15:53,960 --> 00:15:57,440 structures. When it failed, $2.3 billion in 263 00:15:57,440 --> 00:16:01,160 assets simply vanished. Creditors are still trying to 264 00:16:01,160 --> 00:16:04,080 trace the money. The parallels to Greensill are 265 00:16:04,080 --> 00:16:08,600 fairly obvious and troubling. Private credit, which up until 266 00:16:08,600 --> 00:16:12,160 now has been marketed as a disciplined alternative to bank 267 00:16:12,160 --> 00:16:14,640 lending, now looks more like a blind spot. 268 00:16:14,880 --> 00:16:18,360 The bespoke contracts and bilateral relationships that 269 00:16:18,360 --> 00:16:21,480 were supposed to offer flexibility instead just 270 00:16:21,480 --> 00:16:24,680 concealed problems. Pension funds and insurers who 271 00:16:24,680 --> 00:16:28,240 invested now find themselves exposed to risks that they 272 00:16:28,240 --> 00:16:32,120 barely understand. The liquidity crunch is also a 273 00:16:32,120 --> 00:16:35,440 psychological reckoning. Investors are asking hard 274 00:16:35,440 --> 00:16:38,080 questions. What are these assets really 275 00:16:38,080 --> 00:16:40,480 worth? When will I get my money back? 276 00:16:40,640 --> 00:16:44,160 Why does the fund keep reporting gains when they can't seem to 277 00:16:44,160 --> 00:16:46,720 sell anything to outside investors? 278 00:16:47,160 --> 00:16:50,800 Until those questions have better answers, the industry's 279 00:16:50,800 --> 00:16:54,360 reputation for stability will remain under pressure. 280 00:16:54,640 --> 00:16:58,360 The returns may still look smooth on paper, but the path to 281 00:16:58,360 --> 00:17:02,760 realizing them is anything bad. In August, as I mentioned 282 00:17:02,760 --> 00:17:06,280 earlier, Donald Trump signed an executive order that could 283 00:17:06,280 --> 00:17:09,640 reshape the retirement landscape for millions of Americans. 284 00:17:09,920 --> 00:17:13,880 The order allows 4O1K plan administrators to include 285 00:17:13,880 --> 00:17:16,760 private equity and other alternative assets like 286 00:17:16,760 --> 00:17:20,920 cryptocurrencies in defined contribution retirement plans. 287 00:17:21,200 --> 00:17:24,760 The move was cheered by Apollo, Black Rock, Carlyle, and the 288 00:17:24,760 --> 00:17:28,119 other firms that have spent years lobbying for access to the 289 00:17:28,119 --> 00:17:32,160 growing retirement market. The pitch is that these assets 290 00:17:32,160 --> 00:17:35,960 offer diversification, potentially higher returns and 291 00:17:35,960 --> 00:17:39,040 access to institutional grade investments. 292 00:17:39,280 --> 00:17:42,200 But the risks are less widely advertised. 293 00:17:42,640 --> 00:17:46,960 Private equity funds come with high fees, long lock ups and 294 00:17:46,960 --> 00:17:50,240 limited transparency. They're not priced daily and 295 00:17:50,240 --> 00:17:53,920 they're not easy to exit for retail investors. 296 00:17:54,120 --> 00:17:57,200 That's a very different proposition than buying an index 297 00:17:57,200 --> 00:17:59,800 fund. The lobbying effort behind the 298 00:17:59,800 --> 00:18:03,520 order was intense, according to financial disclosures. 299 00:18:03,680 --> 00:18:07,640 Apollo and Carlisle pushed hard for regulatory changes. 300 00:18:07,880 --> 00:18:11,880 Blackstone work through trade associations Mark Rowan of 301 00:18:11,880 --> 00:18:15,040 Apollo argued that the retirement system was 302 00:18:15,040 --> 00:18:17,640 overexposed to mega cap tech stocks. 303 00:18:17,840 --> 00:18:21,080 We've basically leveraged the retirement system of the country 304 00:18:21,080 --> 00:18:24,600 to NVIDIA, he said. The solution, in his view, was 305 00:18:24,600 --> 00:18:26,960 to open the gates to private markets. 306 00:18:27,400 --> 00:18:30,840 Some firms went further. The Defined Contribution 307 00:18:30,840 --> 00:18:35,240 Alternatives Association reportedly argued that four O 1K 308 00:18:35,240 --> 00:18:38,920 plans could be sued for not offering access to private 309 00:18:38,920 --> 00:18:42,080 equity. Their logic being if PE delivers 310 00:18:42,080 --> 00:18:46,200 higher returns then excluding it could be seen as a breach of 311 00:18:46,200 --> 00:18:49,640 fiduciary duty. That argument may be legally 312 00:18:49,640 --> 00:18:54,280 tenuous, but it reflects either the industries confidence or 313 00:18:54,440 --> 00:18:57,920 desperation, and I'll let you be the judge of that. 314 00:18:58,560 --> 00:19:03,280 The Bain report note that retail capital is now expected to drive 315 00:19:03,280 --> 00:19:05,640 much of the industry's future growth. 316 00:19:05,960 --> 00:19:10,120 Semi liquid products, target date funds and model portfolios 317 00:19:10,120 --> 00:19:14,280 are being designed to mix public and private assets, and the big 318 00:19:14,280 --> 00:19:17,640 private equity firms have all announced partnerships with 319 00:19:17,640 --> 00:19:21,760 retirement plan providers. I'm not sure to what extent 320 00:19:21,760 --> 00:19:24,240 American investors will fall for this pitch. 321 00:19:24,440 --> 00:19:28,000 The one thing most investors have learned over the years is 322 00:19:28,000 --> 00:19:30,720 that high fee investments reduce returns. 323 00:19:31,000 --> 00:19:35,360 Average expense ratios paid by investors has been falling year 324 00:19:35,360 --> 00:19:39,920 after year as investors refuse to pay up for underperformance. 325 00:19:40,560 --> 00:19:44,040 The industry's push into four O 1 KS looks less like 326 00:19:44,040 --> 00:19:47,680 democratization and more like a search for new capital. 327 00:19:47,920 --> 00:19:51,680 When the existing investors are frustrated, I guess the trick is 328 00:19:51,680 --> 00:19:54,560 to find new ones. When people from the world of 329 00:19:54,560 --> 00:19:58,640 finance criticize private equity, they often focus on fees 330 00:19:58,640 --> 00:20:01,200 and performance. But outside of the world of 331 00:20:01,200 --> 00:20:04,440 finance, there's plenty of criticism over the industry's 332 00:20:04,440 --> 00:20:08,200 impact on society. What happens when ownership is 333 00:20:08,200 --> 00:20:10,480 distant? Incentives are misaligned. 334 00:20:10,880 --> 00:20:13,880 And the goal is wealth extraction rather than growth 335 00:20:13,920 --> 00:20:17,960 and customer focus. The moral critique centers on 336 00:20:17,960 --> 00:20:21,080 the social consequences of financial engineering. 337 00:20:21,360 --> 00:20:24,840 Congressional investigations into private equity owned dental 338 00:20:24,840 --> 00:20:28,480 chains have raised questions about care quality and 339 00:20:28,480 --> 00:20:32,000 unnecessary procedures being pushed on patients in the 340 00:20:32,000 --> 00:20:35,680 pursuit of profits. Critics argue that the pursuit 341 00:20:35,680 --> 00:20:39,840 of EBITDA Rd. can lead to antisocial outcomes from 342 00:20:39,840 --> 00:20:43,000 understaffed care homes to hollowed out retailers. 343 00:20:43,400 --> 00:20:47,440 Then there's also the antitrust concern around private equity 344 00:20:47,440 --> 00:20:51,240 roll up strategies where PE firms by dozens of small 345 00:20:51,240 --> 00:20:55,240 businesses in fragmented industries like doctors offices, 346 00:20:55,240 --> 00:20:58,720 private schools, restaurants or student housing and then 347 00:20:58,720 --> 00:21:01,560 consolidate them into platform companies. 348 00:21:01,840 --> 00:21:04,600 The result can be reduced company petition and higher 349 00:21:04,600 --> 00:21:08,560 costs for consumers. Private equity thrived in a 350 00:21:08,560 --> 00:21:11,880 world of cheap debt. For most of its modern history, 351 00:21:11,960 --> 00:21:15,600 the industry operated in a structurally falling interest 352 00:21:15,600 --> 00:21:18,920 rate environment. That tailwind is now gone. 353 00:21:19,400 --> 00:21:23,400 A huge component of the business model just relies on leverage. 354 00:21:23,880 --> 00:21:27,280 When rates were near 0, that was cheap and effective. 355 00:21:27,480 --> 00:21:30,880 But as interest rates have gone up over the last two years, the 356 00:21:30,880 --> 00:21:34,320 cost of debt soared. Suddenly, the math doesn't work 357 00:21:34,320 --> 00:21:37,360 that well. Higher rates mean higher 358 00:21:37,360 --> 00:21:41,160 financing costs, lower valuations and fewer exits. 359 00:21:41,320 --> 00:21:45,520 Sellers want yesterday's prices, while buyers can't afford them. 360 00:21:46,160 --> 00:21:50,960 Many PE backed companies now carry 6 to 8 times EBITDA in 361 00:21:50,960 --> 00:21:54,560 debt levels typically associated with junk credit. 362 00:21:54,880 --> 00:21:58,760 When interest rates rise, bankruptcy risk rises with them, 363 00:21:58,920 --> 00:22:02,000 and the private equity model starts to look a lot more 364 00:22:02,000 --> 00:22:05,640 fragile. Private equity firms argue that 365 00:22:05,640 --> 00:22:08,240 they can operate in any business environment. 366 00:22:08,400 --> 00:22:12,720 But with inflation, tariffs, and policy uncertainty, all of which 367 00:22:12,720 --> 00:22:16,280 hit smaller businesses harder than large businesses, it's 368 00:22:16,280 --> 00:22:20,200 become increasingly difficult to underwrite new deals with any 369 00:22:20,200 --> 00:22:23,280 confidence. Private equity has always 370 00:22:23,280 --> 00:22:26,200 pitched itself as a sophisticated alternative to 371 00:22:26,200 --> 00:22:28,360 public markets. It claims to offer 372 00:22:28,360 --> 00:22:31,760 diversification, excess returns, and stability. 373 00:22:31,960 --> 00:22:35,200 But the reality is more complicated than that. 374 00:22:35,560 --> 00:22:39,040 The returns are driven by leverage, and the stability may 375 00:22:39,040 --> 00:22:42,920 be an illusion, like a toddler's drawing of a roller coaster 376 00:22:42,920 --> 00:22:46,320 labeled steady growth. The diversification? 377 00:22:46,520 --> 00:22:49,840 Well, that's mostly concentrated bets on small, cyclical 378 00:22:49,840 --> 00:22:54,600 businesses that panic at the side of higher interest rates as 379 00:22:54,600 --> 00:22:58,760 the industry expands into four O 1 KS and retail products. 380 00:22:59,040 --> 00:23:02,720 The pitch is being repackaged, but the fundamentals haven't 381 00:23:02,720 --> 00:23:05,640 changed. The fees are high, the exits are 382 00:23:05,640 --> 00:23:08,000 uncertain and the returns are shrinking. 383 00:23:08,400 --> 00:23:12,280 Retail investors are being sold a feature, but they may instead 384 00:23:12,280 --> 00:23:15,760 be buying a bug. The Mirage of sophistication is 385 00:23:15,760 --> 00:23:20,000 powerful, but eventually the water seen in the distance has 386 00:23:20,000 --> 00:23:22,520 to be real. And for private equity, that 387 00:23:22,520 --> 00:23:26,720 means actual exits, actual distributions, and fewer 388 00:23:26,720 --> 00:23:30,400 PowerPoint slides about transformational value creation. 389 00:23:30,840 --> 00:23:34,800 Until then, the industry may look smooth on paper, but it's 390 00:23:34,800 --> 00:23:38,520 starting to sound like a bedtime story told by someone who's 391 00:23:38,520 --> 00:23:42,120 already spent your retirement. Thanks again for tuning into the 392 00:23:42,120 --> 00:23:44,600 podcast. If you found it interesting, I'd 393 00:23:44,600 --> 00:23:47,800 appreciate if you sent a link to a friend to help the podcast 394 00:23:47,800 --> 00:23:49,880 grow. Have a great week and talk to 395 00:23:49,880 --> 00:23:51,320 you again soon. Bye.