Ep. 362: Dan Rasmussen on Private Equity's Stranded Assets, Private Credit, and the AI Bubble

Greetings and welcome, Dan. It's fantastic to have you on the podcast show.

And I went into law and the people at the bottom of the class who aren't as smart Went into business and they've made three times as much money as I did, retired ten years ago, didn't work as hard. So you should try this business thing. It seems easy. So, you know, I I that was good advice. He also said, you know, I get paid by the hour. You should try to find a job that pays you by the decision.

And so really my dad had a lot of influence in suggesting that I go into into business. And so I I basically just uh applied to a bunch of random places and ended up getting investing jobs for whatever reason. And and that's sort of uh what led me in here. So there's a lot of randomness or fate or or God or however you want to look at it.

Consensus view. And that could reflect a lot of disagreement. It could, right? But so that your question isn't, you know, you do your own analysis. But without an understanding of how your analysis relates to that market pricing, you know, right, you could say, Hey, I think SpaceX is a great company. Right, but so do a lot of people, right? So it doesn't get you there, right? You have to say, How do I really think do I like SpaceX more than the consensus or less than the consensus?

And I think there are so many parts of the world that are very unpredictable, right? It's really hard to know the future. And so when you start to think about investing, what I like to look for is places where the consensus is pricing in a clear future.

where the consensus feels confident that something is gonna happen. Because that my view is that things are surprising and unpredictable. And so if you can find places where everybody's pretty convinced that X is going to happen, then just consistently take the opposite end of that trade. And uh, you know, I think there are a lot of different examples of that. But, you know, the one that I've probably talked the most about over the years was the massive consensus push into private equity.

which I just thought was, you know, at the point where everybody agreed that it was a good idea and that private equity was the best performing asset class. you know, it almost couldn't be true, uh, just merely by the uh sheer weight of the consensus opinion. Um and I think we're certainly seeing the fruits of that consensus thinking uh now in the market.

And then using a lot of debt to buy it. And so if you've got multiple expansion or the company's value increased, you earned a you know multiple of that because you were so levered. And that was sort of the original idea. And that worked, you know, very well for a while, you know, because basically you were buying, you know, microcap deep value with leverage and uh, you know, it was a good strategy.

But what happened is that it started to become consensus among institutions that one should have a private equity allocation. And then the size of that private equity allocation went up and up and up.

And then you introduce sovereign wealth funds who thought that they should copy the endowments and you know, Audia and Oddic, which were, you know, uh trillion dollar uh pools of capital, saying, gee, you know, we should put four hundred billion dollars into private equity or something over the course of a decade.

So you had this huge flood of money. But remember the companies themselves were very small, right? They were too small to public, you know, generally too small to IPO. And so, you know, these inflows of capital really moved the market for private companies. And it made it much more expensive, much more competitive. Every deal is going up for auction. Those auctions are getting 50 bids, 60 bids from different private equity firms, all funded by the same custom constellation of people.

And what's sort of it was sort of interesting what happened and and so that dynamic Of a sort of the flood of capital pushing into private equity, I'd say was largely accomplished in the early by the early 2010s. So, you know, the market had become fully efficient, fully priced.

by the mid twenty tens. And at that point, you know, the the smart people in private equity, because remember they're very smart, said, you know, how do we you know, we're clearly having to pay big prices, much higher prices than we ever paid for companies before.

But how do we justify that? Right? Like we can't go buy like some industrial distributor and pay like eighteen times EBITDA and claim that we're doing like a good job for our like our LPs are gonna kinda see through that and like how do you underwrite

How do you underwrite an industrials deal, those valuations, right? So what they decided to do is that hey, we really need to find things that are growing materially faster than the rest of the market. And well, what was growing materially faster than the rest of the market? Well tech.

and healthcare tech software and healthcare software essentially were the things they they landed on. And there were some early examples at Toma Bravo and Vista Equity, who were doing really well with those type of deals. And so the large wave of PE just said, hey, we want a copy Vista and Bravo Bravo. We want to buy these really good businesses, right? We're now paying high enough prices. We really want to pay really good businesses.

So private equity shifted from in the nineties and eighties and early 2010s was essentially a small cap value trade or micro cap value trade into a smaller microcap growth trade. where they were sort of a, you know, an extension of venture in some ways. And they were all in on software and this idea that software is eating the world.

You know, generally I think for most private equity firms, forty, forty percent or so of the capital during that twenty fifteen to twenty twenty five period call it, was flowing into tech. into software or software adjacent things like healthcare software, which you could classify as healthcare, but really we're healthcare software.

Like and underperform was not even like an option. Like it wasn't even like, you know, it w literally, it was literally complete consensus. And they were plugging historical returns and saying, Hey, private equity is quote unquote the best performing asset class.

And therefore we should have as much money in the best performing asset class as we can. And the number that they sort of circled in on was forty, forty percent. We should be forty percent in private. And that's what Yale and Harvard ended up at and a bunch of other, you know, smaller endowments. Even though the sort of uh you know, market cap weighted size of private equity as an asset class is probably about four percent of the market cap of the public equity market.

So if you're sixty percent public equities, you should be, you know, three percent private equity at market cap weight, but that's not how they thought about it. They thought, well, it's the best performing asset class, we should follow the endowment model, we should be forty percent in it. And then I think Within private equity, you were saying, Well, I want to invest in the best performing managers. Well, who are the best performing managers? The ones with the most.

Software exposure, because that was what was hot. And software was supposedly eating the world at the time. And then, you know, what sort of capped it all off, the sort of thing that created the Final frenzy, the extinction burst was um there were a bunch of deals done in 2018 and 19 at very high prices.

And a lot of the skeptics were saying, hey, this stuff is crazy. Like we shouldn't be paying these types and even for software, we shouldn't be paying these type of multiples. Then COVID hits and all of a sudden all tech is like. Valued like an insane amount. So all those expensive deals in 2018, 19 were golden, right? Like that you could there were huge winners.

And so then that was the moment where the lights went on and people said, It doesn't matter what you pay. If you're buying a great software business, it doesn't matter what you pay because it didn't matter in twenty eighteen, nineteen. Look at the returns we made. We actually could have paid

two or three, four or five turns more for that business, and we still would have made three X our money at current valuations. The key thing we need to do is put the most money into the ground and software as fast as possible. Forget the valuations. These are just great businesses. And that was sort of the peak, right? The the blow off the top peak in in software private equity. So those twenty twenty, twenty twenty one, twenty twenty two, twenty twenty-three vintages uh before.

Really, the dawn of AI. And the dawn of AI is really what killed the deal, you know. But um, but rising rates were also a huge problem. And the reality that those Companies that were bought in those periods just clearly underperformed the underwriting expectations by big margins. And then when rates rose,

the sort of that sh question, the refinancing, and that was the first big blow. And then AI arrived and that was of course the much bigger blow. And now private equity software deals are essentially stranded assets. Why are they stranded assets? Because if you're a private equity firm and you go to your LPs and say, Hey, we just underwrote a software deal or we're buying this software company from this other private equity firm.

Your LPs aren't saying, hey, great, you know, slap on the back. What a great deal. We're so excited. They're saying, why did you bail them out? You know, and more money into software? Why? And so basically the private equity deal machine and software is shut. And since these companies are too small to IPO, and even if you did IPO them, who wants a really levered microcap software business? They're dead in the water. What do they do?

It's not true in mutual funds, it's not true in private equity, but you know, but there is real persistence in venture where a firm that's been generating good returns continues generating good returns in private equity. There's no persistence of uh performance. And so you have sort of fads, I would say, and what allocators allocate to.

And uh, you know, you can sort of trace it out. And it was interesting in sort of the twenty ten to twenty fifteen period, um, energy private equity was really hot. Everyone wanted to get into energy o oil prices crash and fifteen, like that is over.

And then twenty fifteen to twenty twenty was twenty twenty three, twenty four was the software boom. Everyone wanted to be in Vista, Toma, every m big private equity firm other than Apollo uh wanted to copy Toma and Brist Vista and do exactly what they were doing. And then you recently had a consensus trade or pretty consensus idea where if you talk to any endowment or foundation, they would say, we underwrite middle market private equity. We underwrite like differentiated mid-market managers.

The sort of funny thing about that is a big academic study came out this year, which suggests that the bigger the fund, the better the returns. So the whole mid-market strategy was. sort of wrong, but it looked right because the dispersion was higher. And so what everyone looked at is they said, well, who are our best managers in our portfolio? And they were all mid-market bio.

And so they said, Well, we need to do more mid market buyout. What they didn't realize that that the tail, their worst performing managers were also mid-market buyout, as they would discover in time. Uh, and therefore that the median returns of this stuff was actually worse than large cap buyout, which in turn is now worse than public markets by a lot big margin. And all of it uh is of course totally illiquid and super high fee. So you're gonna be stuck paying.

you know, four or five hundred basis points and fees into eternity on these illiquid allocations.

Uh we offer highest of yield, we offer, you know, we have good sort of uh due diligence, everything's kind of uh we over collateralize. I mean they they have all of these sorts of terms and so on and banks aren't lending, so we're filling a market gap. You know, so how do you think about private credit?

uh that expected return equals yield minus losses from default. And so when someone says, hi, I have a really high yielding product, your view should be, well, that means that it must be a pretty high default risk product.

Right. No one comes out and say, Well, yeah, I'm doing payday lending at forty percent yields. Like you should come and you're gonna get a forty percent yield doing payday lending. Right. Like people are like, Well, you're probably taking the forty percent yield because your borrowers are so risky. And you know, your first sort of clue to that is the pitch itself, which is, well, the banks have exited this market.

And you're like, but but I thought banks were really greedy, right? Like banks uh you know, the banks have left the market. Why do the banks leave the market? Right. Like, don't the banks want to make money lending? Like, why would they not be doing it? And they're like, Oh, they think it's too risky. And you're like, Okay, so the banks think it's too risky.

And the yields are really high. So like what should I be thinking? It's like, well, I should be thinking it's really risky. And then you're gonna say, well, what is it that you're doing exactly? Like what is private credit? Like what what who are we lending to?

And then here's the trick. They're lending to private equity firms to but do leverage buyouts. And that's where the overcollateralized thing comes in, right? They're saying, Hey, look, you know, yeah, we we're lending a lot of money to this business, but

You know, there's uh for every dollar we're putting in the equity there's a dollar of equity, you know, that's uh subordinated to us. So and if you you think private equity is amazing, you know, you've gotta believe that the private equity guys are gonna lose their shirts before our Capital is at risk at all. So it doesn't seem risky unless unless you think private equity is bad. How possibly could you think private credit is bad? Like it just isn't risky at all.

And it hasn't been risky. Like, look, not you know, no private credit deals went bankrupt in the 2010s, right? Like, well, no other companies went bankrupt in the 2010s either, but like it was great time to take risks.

And then where they also had their moment, interestingly enough, was a little later where where when yields spiked, bonds sold off, but because all of private credit was floating rate, they actually weathered that storm fairly well. Then, however, their borrowers who are risky to begin with, now because it was floating rate debt, had just like a huge amount more interest.

to pay and they couldn't pay it for a whole variety of reasons. And so what you started to see is deterioration of the quality of the loan portfolios, which of course was inevitable and predictable. And retail investors started to say, wait a second, you know, isn't this kind of dangerous?

And isn't a lot of this lend loans to software companies and private equity? And isn't AI gonna disrupt that? And so people started dumping private credit. And as people dumped it, they said they gated. And then people said, well, if it's gated, I would need to put myself in line. So if I want to get out, I can. And then the gates looked worse and the lines looked worse. And then it was basically a classic sort of s bank run type scenario.

And sort of the funny thing about that was that it wasn't yet happening in private equity, even though private equity was subordinated to private credit. So private credit was bad, private equity sorry, private credit was bad, private equity has to be worked. And I think that, you know, you're starting to see that dawn on people. You're starting to see outflows from evergreen funds.

But somehow, even as sort of the reality of the difficulties of private credit has dawned, n it hasn't yet totally registered with people that their private equity portfolios are really a bunch of crappy microcab software companies with too much debt that are essentially unsaleable.

So we are we're gonna take ownership, we're gonna have control. These expenses are non-recurring. These expenses are things the old management team did that we're not gonna do. And therefore our real evitah is X. And the sort of best studies of it have suggested that um that adjusted EVITA was around thirty-five percent higher than what.

actual EBITDA was. And in that that was sort of the latest numbers, you know, 10 years ago, maybe it was 10% higher. But as the boom kind of continued, people saw that this was just sort of a logical way to fudge the numbers and it just went up and up and up. And so what that means is that your year one evitah almost always disappoints. You know, ninety plus percent of the case your year one evitah is gonna be below your projections because you were taking an adjusted EBITDA.

And then you were saying that that adjusted EBITDA was gonna grow. And so, you know, there's like no way that your company could actually grow Ebata by that amount. So i there was sort of this inevitable wave of disappointment. And that's really, you know, one of the things that's driving the deterioration of results here.

strategies. There's this notion that if you just invest in small cap companies, there is a premium you can earn over time. And then so people have done that as a smart beta strategy or some kind of factor strategy and then lever that up as well just to juice juice the returns. I mean, do you think there is a genuine style or sort of risk premia there or is it just some kind of uh empirical, uh historical illusion?

Now, there's a another element of this, which is that size for a variety of reasons in public markets amplifies factor premia. So if you're looking at a large cap value stock and a large cap growth stock. The fact that one is value and the other is growth says very, very little about their future returns. They're just big and the markets efficiently price big companies. And so it doesn't really mat factor investing doesn't really matter at that scale. You go down into small caps.

The it it actually predicts a meaningful bat um amount about uh future returns. And so I would always argue that small size is an amplifier for good or bad decision making. And I think what happened in private markets is that size, combine that with, you know, very expensive prices, a lot of debt, and a huge software overweight was creating just sort of like a perfect storm of bad portfolio uh, you know, construction where you were just overweight.

Small cap growth, which is the most cyclical, worst-performing long-term sector of the market by far. You are adding leverage, which makes things even more risky. And uh you are doing so at, you know, four or five, six hundred basis points of fees. And, you know.

As dumb as that sounds, if you walked into Harvard Endowment or Yale Endowment, what and you said, Hey, what do you think of this? Like, do you want to put half your money of your college into micro cap growth equity investments done at multiples that are a premium to the SP five hundred with, you know, 10 turns of leverage at twelve percent.

per year. They would say, great, let's do it. That sounds awesome. Can we do more? You know, we give you longer lockups. Uh can we do even smaller companies so we can really get access to the mid market? You know, it was just like the most sort of like dissonance between like what was actually being bought and sort of the love affair by this uh very, you know, consensus driven culture that was created among the sort of institutional allocator community.

Well, uh, we see that there are times where in capital intensive industries people say, Well, my capacity, my manufacturing capacity for this product is way too small. There's essentially unlimited demand. For my product, I could triple the size of every factory I own and still sell all of my goods. And so I really need to massively expand capacity in order to meet the sort of seemingly infinite demand.

Um at current market prices. And you can see that phenomenon in energy, go back to like fracking in the 2014 period, right? Like there was no dollar amount that you could put into fracking new wells that didn't seem like a good idea. Because oil prices were really high and so economically it made sense. Or you look at the shipping industry, which goes through these big booms and busts, and people say like,

There's just not enough ships. We couldn't make enough ships to satisfy demand right now. You can look at almost any capital intensive industry. And what you see is that the problem is that as you're expanding capacity, everyone else is already expanding also already expanding capacity, which means you inevitably get uh overbuild and you inevitably get then therefore collapsing pricing. And then those massive capital investments, the ROI looks a lot worse than what you underwrote.

and the extent that you borrowed defund it, it creates a huge amount of problems. Uh and then you have to have a period where the sort of inventory, you know, the capacity overbuild, you know, uh sort of uh clears. And so we're almost certainly going to have that. Uh, you know, when will capacity exceed

demand. I don't know, but the second it does, there is going to be a collapse in prices, right? Like and that collapse in prices is what's upholding this. You know, those prices are what's upholding this entire thing, right? Like, well, if If AI if selling AI, like if if being a sort of uh, you know, an AI provider is massively money losing. Well, like OpenAI and Anthropic and all these other things are just like, well, what do we spend all that money on? Like those NVIDIA chips.

And then what about all the semiconductor companies who say, well, now there's no orders right now because there's overcapacity? Like so demand went from infinite to zero, like that. It just gaps out. And that's what happens in capital intensive industry. Demand goes from infinite to zero as capacity exceeds demand. And I don't know when that happens, but like,

Could it become massive? Could we somehow achieve efficiencies in AI, uh uh compute that make our capacity overbuild like clear in like a minute? Like, I don't know, could happen. Uh, I think there are a dozen different ways that could happen. But I will say with certainty that it will happen and I will say with certainty that um the market is priced that it will never happen right now. And so uh that is where I think um there's very clear signs of a bubble.

And I think that is saying nothing about the technology itself, which is amazing. AI is amazing. It's wonderful. It's it's awesome. You sh everybody should be using it uh to the extent that they're a knowledge worker. It's great. Um it's gonna disrupt all sorts of things.

But that, you know, oil's really awesome too. And that doesn't mean that there aren't uh big capex cycles and boom busts in the oil market, which is even more essential to our economy than AI. So You know, just because AI might become essential to the economy and might be massively beneficial to everybody, uh, doesn't mean that it's not a cyclical commodity capital intensive business.

I want to be all in on the diversifiers, right? Like uh, you know, like I don't want to touch the bubble stuff, right? Like I think that You know, like they're always like hot investment strategies, right? Where you invest in manager A who's had an A amazing returns and they keep having amazing returns for three to four years.

And their AUM surges and then the thing just collapses, right? Like their uh markets are littered. There's graveyards uh full of funds like that. The winners are the people where the market goes like this. And they go steadily up over a long period of time without that boom bust. And so I think that the boom bust risk in um uh as a fund manager of being involved in that stuff is way too high. Uh and there are many other people happy to play that game.

I think as an allocator, you know, if you're thinking, you know, you're running an endowment or foundation or family office or managing your own personal money, I tend to think that. You know, you you have to again start from efficient markets and say, hey, you know, the markets could be a bubble or it could be totally right. Now, if I am really bearish on AI.

I should be underweighted. I shouldn't not own it, but I should be underweight. And how underweight should I be? You know, how risky? How much tracking error do I want to take in my portfolio? You know, I tend to think um if you're managing other people's money, you know, something like a 10% off benchmark bet is probably a lot, you know. Um, and so you'd say, hey, I wanna be 10% underweight.

You should put zero percent of your money in privates. It's just dumb. Uh like you're gonna get effed and you're you know, you're gonna get find out that you were effed at the worst possible time and nobody needs to pay super high fees.

You know, like it's like paying four, five, six hundred basis points and fees, just too high for most almost everything. Um, and so that bar has to be really high for you to want to do it and Um, if everybody and their mother is putting forty percent of their portfolio into it, it's probably a bubble.

I don't know. Like have call center is there like a have call centers figured this out? Have we gotten rid of all call centers? No, like there's still call centers, right? Like the call centers should have like if AI really works. They should be able to replace call centers, right? Like you you're taking an entry-level employee and having them answer like tech support calls.

and you can't get that automated by AI, like is a big blow against AI. Um, and I'm telling you, call centers are fine right now. Like they have not been replaced by AI yet. Maybe they will, but they haven't. So you go like your job is like an entry level a legal associate or an entry level this. If they haven't figured out how to replace call centers, they probably won't have figured out how to replace your job. So I think right now, um, and actually if you are good at using AI.

your productivity and value to the firm might be three or four X higher than it was for someone who can't use AI. So I would say figure out how to use AI, like make AI help you work to your advantage, like become You know, like don't sit there and be like, oh no, AI is gonna steal my job. Like AI is only gonna steal your job if you can't use AI to make yourself better. And you should be able to make use AI to make yourself better because AI is a great tool.

And so I think that's where the focus, you you gotta have this optimistic growth mindset, right? Like figure out how to use the new technology. You're young, you can do it. You'll be faster at it than anyone else. You'll be more native in it. Make it your str super strength. Uh don't whine about how it's going to replace your job when it hasn't even replaced call centers yet.

broadly is to not compete against Vanguard and not compete against index funds. And so we try to do things that are sufficiently uh offbeat, uh niche, idiosyncratic. uh capacity constrained, you know, you name it, and we try to figure out niches of the market that we think are mispriced, inefficient, weird. and build those for our clients. Um, so we do a variety of random, seemingly disconnected things, but that are all united by that philosophy.

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