The Risks and Realities of Private Equity, with Dan Rasmussen

in twenty seventeen. Thank goodness, we have a savior. It's the private equity business. The belief, simplified, is that private equity will invest in private companies or buy public companies and take them private. Those no doubt brilliant investments will play out perfectly and help us achieve the returns we need in our health and retirement benefits will be secured.

The chief investment officer of the California Public Employees Retirement System, which is the biggest pension fund in the United States, recently advocated putting more money in private equity. His quote, we need more of it, and we need it now. He was a risk officer at Lehman Brothers. But anyway, he's far from alan what insiders called dry powder. The amount of uncommitted capital that private equity firms can invest now exceeds two trillion dollars. But what if it's not true?

What if private equity isn't going to make our retirement plans fat and happy. This is a question with huge ramifications for pension funds, for those who depend on them, and for our markets. After all, some private equity deals have gone wrong in very public ways. Look at Toys are Us, which buyout firms Bane and KKR, along with Fornato Realty Trust acquired for six point six billion dollars

in two thousand and five. When Toys are Us filed for bankruptcy in two seventeen, the toy company said it had five point three billion in debt and was paying four hundred million a year in debt service payments. Over

thirty thousand employees were left without jobs. In late June, San Jose Inside newspaper published a piece noting that San Jose's two pension funds hit up the amount they were putting in so called alternative investments from less than ten percent to almost fifty percent over the decade spanning from two thousand and six to two sixteen. Over that same period, those two plans posted returns that were consistently lower than ninety nine percent of their peers. So there are some skeptics.

Chief among them is Daniel Rasmussen, himself an investor, although that's probably too simplistic an introduction. Another investor has likened Rasmussen to the fighter pilot Maverick in the movie Top Gun because. In a very controversial piece published in American Affairs last summer, rasmusen dismantles what he says are the three assumptions that underlie the boom in private equity. One that private equity firms make money by improving the companies

they buy. Two that private equity is less volatile and less risky than public markets, and three that private equity will significantly outperform every other investment. Resmussen writes there is near complete consensus on these three points among academics, investors, and private equity firms, and he believes that the consensus is dead wrong. I have to admit, whenever I hear the phrase near complete consensus, I get nervous too. So I'm thrilled to have Daniel here with me to discuss

the risks and realities of private equity. After working at Bain Yes, a private equity firm, and Bridgewater, a hedge fund, Dan founded his own firm called Verdad Advisors. Dan is also the New York Times best selling author of American Uprising, the untold story of America's largest slave revolt. So, Dan, what do you think when you hear the phrase near complete consensus? The most dangerous thing in financial markets is

consensus because consensus is what drives bubbles. And I think what's really frightening about private equity today is that over I think a recent Prequin service at over ninety four percent of institutional investors believe that private equity will outperform the public equity markets by greater than two percent per year.

And yet you cite in the piece you wrote this Cambridge Associate study that showed that private equity returns have actually lagged the Russell two thousand index by one percent in the S and P five hundred by one point five percent a year over the past five years. Why is there this gap between perception and reality? Largely because the returns prior to two thousand and six were so good. So, before private equity became the hottest asset class, it was

a relatively niche alternative. It was largely pursued by some of the smartest people in the business, pioneered by Yales and Dowmen and others, and it worked really well for about twenty years. And in the late mid to light two thousands, people started to realize how well Yale and others had been doing in the asset class, and they started to pile in. So all the performance stats that people look at include this wonderful pre two thousand and

sixth period. Even though the post two thousand and six period has been mediocre, it hasn't yet been disastrous. And so people combine the mediocre returns the great returns. They say, ah, where also are we going to look for something that is a good chance of beating public equities? So, in a sense are they victims of their own success? Of course,

and this is a perpetual story in markets. Everything begins as a good idea and then Wall Street packages it up and sells it, and if it keeps working, it gets to be a bigger sales pitch, and the more money that flows in, the more efficient the market gets. And if more money keeps pouring in and the opportunity set is small, that's where you at really bad market conditions. So we've talked a lot on my show about Wall Street being such a short term machine, and I'm always

interested in the places that seem to get exemptions. And so why is it that people are willing to give private equity so much credit for past returns that are so long in the past. One of the great allures of private equity. One of its big attractions is the way that the returns are accounted for. So, because private equity is private, the returns are calculated by accountants that are employed by the private equity firms, who issue statements on a quarterly basis saying what each company in that

private equity fund is worth. And those are highly subjective marks, and they tend to track the financial metrics of those businesses much more than they track the market. So in Q four, for example, markets were down fifteen twenty percent Q four eighteen, private equity marked down their portfolios and

aggregates somewhere between zero and five percent. Right, wow, So either of these private equity guys are super geniuses who generated fifteen percent of alpha in a three month period, or the way they're marking their assets isn't truly to market. And I think the reality is that they're not marking them to market. They're marking them to what they think they're worth. And that might be a very thoughtful, elegant, intellectually correct way of valuing them, but it's not. The

markets are not efficient in that way. They're much more volatile than they should be. And so because these returns are artificially smoothed, people have grown lulled into complacency. And there's always the case that someone can say, well, yes, I know it hasn't worked over the past three years, but it's early in the funds ten year. This is a ten year fund. It'll be marked up over time.

It always has been. And these are the dynamics that allow people to get fooled and lulled into complacency and not get any feedback about whether their investments are working or not. I think you used a line in your piece that I loved that the CIO of the Public Employment Employee Retirement System of Vitaho called this the phony happiness of private equity. It always makes me. Think of my favorite line from the Sun also rises? Isn't it

pretty to think? So? That's exactly right, Much prettier to think so than to admit that these returns may actually not be all they're cracked up to be. You had a great example in the piece you wrote of this too, not just the fourth quarter of two thousand and eight, but what happened when energy prices crashed in twenty fourteen

and twenty fifteen. Do you want to walk us through that? Yeah, So, you know, oil prices dropped more than fifty percent, maybe maybe even seventy percent or something like that, and private equity energy private equity had been it, you know, investment class, which it is again now now for reasons that you've documented very well, don't make sense to me. But these private equity firms had bought a lot of shale drilling firms. They levered them up much more than other investments in

the industry. Public energy stocks were generally down about fifty percent, and I think at the time I wrote this piece in the middle of twenty sixteen, the private equity assets were not marked down at all, So they were marked at one right, so they even the twenty fourteen and fifteen vintages were marked at one. So they deployed a bunch of money and highly levered very small shell drillers.

And even though the public equival was down thought fifty, oil prices were down sixty or seventy, right, they were marking them at one. There was one energy pe executives asked you, why is it that your portfolios marked at one? He said, well, we're looking through the cycle when we make our valuations once again. Isn't it pretty to think so? Right? I saw a quote actually that some eighty two percent of people in private equity use internal valuations rather than

any kind of external benchmark. Why do investors let our investors just so desperate to believe that it's in this lack of volatility that they allow private equity firms to get away with it? Yeah, I mean, I think we're living in an age where everyone thinks back to the pain of O eight. I mean, I think it's very much on people's minds private equity. I think the Russell two thousand small cap index was down about sixty percent, peeked a trough and eight private equity was marked down

about thirty percent. And so if you're sitting there on the investment committee of one of these pension funds or college endowments. You look back at that experience and you love private equity because that's what allowed you to sleep at night during that period, or to tell your committee that you were beating the market or you weren't down as much as the S and P. Right, you know, our and dowment did fine through the crisis. And of course it was a myth. But it's a myth that

everybody is happy to believe in. I mean, markets are too volatile, right, I mean, nobody likes it when their portfolios down fifteen percent in three months, and this offers a pleasant alternative. Why do you think it continues with all of the warning signs that are building up to be so easy to sell private equity firms, institutional investors, It serves a pleasant fiction that a lot of us would like to believe in. It's like your quote from

aus Son also rises. I think we'd like to believe that very smart, well educated Harvard Business School graduates can run companies better than other people, and that if we meet them and we really vet them, and then they go and buy these companies and they don't just buy a piece of them, right that they buy the whole company, and they really sit on the board and they work really hard at it, and they can improve the companies. David Swinson, who's the Yale endowment manager. So this is

a superior form of capitalism. Yes, it's just better. It's managed. It's managed by just the type of people you think should be able to manage it very well. Okay, so we've addressed your first myth that these funds are not less volatile. It's just the accounting that actually helps them look less volatile, the accounting we're all actually willing to buy into. And now there's this myth. One of your

other myths is that they actually can improve companies. And you've actually done a lot of work showing that that's not true. It's not just a belief of yours. And what's the most compelling thing you've found that made you say this just isn't true. What do I want to address this question? It's hard because private equity companies are private. So what I looked at is every private equity deal

where the company has issued public debt. Okay, so when you issue public debt, you have to report your financials at the time of issuing the debt, right, which is when the transaction occurs, So you have the pre transaction financials, and then of course you have to report to the market what your returns are afterwards because the data is public. So I found about I think three hundred or so deals over the past a decade which I'd issued public

dat so it's a pretty broad cross section. And then what I wanted to look at is pre acquisition what the financials were, and then post acquisition and see if, of course operational change is happening, and if it's happening at a magnitude which is driving this very superior performance to the public equity market. I figured it should be obvious, right,

I mean, I shouldn't have to look too hard. So first I looked at trends in revenue growth YEA, and broadly what I found is that revenue growth slowed post acquisition. That's actually stunning, but it's not stunning if you think about it in a different way, which is that private equity firms want to buy good companies, so of course they're going to select for companies that have been performing well, which are going to be firms higher revenue growth than average.

But if the world reverts to the mean and there's no skill, then you'd expect to see above average growth in the past and mean growth afterwards. That's what you see. And then you look at margins. So okay, well, maybe maybe the private equity guys aren't driving revenue. Maybe they're brilliant cost cutters, maybe their efficiency geniuses. There's such a thing as being a brilliant cost cutter. Maybe Okay, aggressive cost cutter, savage cost cutter, a predatory costcutter. I get it.

But I saw basically no change in margins pre and post acquisition. So it wasn't like revenue growth was expanding. It wasn't like margins were expanding. So what did change, Well, very systematically, in every deal observed, there was a massive increase in debt. And with a massive increase in debt, a massive increase in interest payments, and because of the massive increase in interest payments, generally a contraction and investment spending.

So if you think about what is the operational playbook from a data perspective, the operational playbook is to add debt to companies. That's it. That's the leverage buyout it's private equits just a story of debt. It's a story of debt. Does this make private equity sort of a parable for our times in the sense that this is the era of debt? Yeah? And I think that post oeight a sort of a set of interesting things happen, right. I mean, one is that interest rates obviously dropped a lot.

Two is that the FED really intervened to abrogate the default cycles. There are fewer defaults in O eight than there were, for example, in OH three, So I think a lot of people got lulled into complacencies. They say, Okay, we can take risks with debt because interest rates were low and the Fed's going to bail us out, so why not go down the quality scale, take a little bit more credit risk. Surely it couldn't go wrong. And

that's large to what we've seen in private equities. So, you know, the debt levels have just risen and risen and risen and risen. And because of regulation, the banks are no longer the ones public banks are no longer the ones providing the stat financing. Now it's in the private lending market, the business development corporations, the mid market lenders, the clos this whole heave of alternative lenders that are the ones providing this debt. And these are firms with

very little track record. They're new firms, they don't have a lot of experience, they haven't gone through cycles. They're very aggressive, and they're willing to lend to all our companies more money than banks ever would have lent. And they're willing to do it. And this is sort of a very common thing that goes on in the industry on ProForma financials. So the FED, for example, put it rule in saying banks shouldn't lend a company is more

than six times IBADA. So what happened in the wake of the crisis is that a lot of these private lenders and mid market lenders said, Okay, of course we're not going to lend more than six times EBITDA. But you, the private equity firm, tell us what IBADA is right, Because EBA does a made up number. It's not a it's not a net income, it's not cash from operations, almost whatever you want it to be, not quite exactly.

So it's called ProForma ibnore all the bad stuff, earnings before all the bad stuff, and Moody has just done a study on this found that proformat ibada was generally about thirty percent higher than gap ibada, never lower. So I want to come back to this because this seems to hint to me at kind of round two of the shadow banking system that played such a dangerous role

in the financial crisis of two thousand and eight. But you you said something when you were mentioning the lack of operational improvement to private equity firms that I found fascinating, which you said that there it's actually less investment, that

they cut back on investment. And I find that really interesting because part of the marketing of private equity is that it's an escape from the short termism of the market that by allowing companies to be in private hands and to not have to meet quarterly earnings expectations, you can invest more and you can allow companies to take the big bets on businesses that we all want to see them make. Your data would seem to suggest that's

not true. Lookt decreases your flexibility, right If you o lenders a huge amount of money, right, you don't have the flexibility to take some big, large scale bet And these firms are not taking out debt to fund building of a new factory. They're taking out debt to fund the acquisition of themselves. So I think that just simple logic would suggest that the firms that are going to

invest a lot are not the most levered firms. How do you think about the returns garnered from the big dividend payments that it be comes such a feature of private equity because I might be wrong, but that strikes me as new. So back in the battle days of financial engineering, right, private equity firms didn't routinely do that. They didn't add on debt and pay themselves a big dividend and get their money out the way that happens in so many transactions today. Am I right about that?

And is that a relatively new feature that is, yes, contributing to what returns there are, but also potentially quite problematic both for future returns and for the state of

these companies. Yeah. So this is going to come back to the lessons learned from O eight, And one of the lessons learned from O eight by the private equity funds was that they bought a lot of things in a six or seven and then they couldn't get any money out of them until twenty ten or twenty eleven, right, so they were had this long period where they'd put cash in and they didn't get cash out, and that hurts.

The key performance metric for private equity is called the internal rate of return right and time based, and it's time based, so you have to have a short window between when you put capital to work when you return it. And so all the IRR on the oh six and oh seven vintage funds were really low, and so a lot of firms convince convence study groups to say, okay, well, what are we going to do to make sure our

RR numbers are attractive. And one of the things that they came away with is that you need to return capital early on in the investment. So you need to shorten the time between when you deploy capital when you give it back. So there are two ways to do that. One is you take out a subscription line of credit, so you buy a company, so you close in March, you borrow all the money you need for the closing, and then you wait until December to call the capital

from your investors. So you've shortened the investment period by about nine months maybe, So that's a subscription line of credit that you do on the front end with yet more debt, with more debt, right, but it's short term debt, so it's pretty low rate, but it really helps the RR. And then the second thing is after about a year, if the operational metrics are good, and usually if there's anything you can generally forecast better, it's very short term

results right after you buy something. So you buy it, maybe you make the quick fixes, ebit does up a little bit, You go back to the bank, you say, look, EVA does up five percent or timbercent. We can take out tim percent more debt, and we're going to do that. We're gonna refly at we're going to pair ourselves at dividend and then they get cash back really fast. So now their rrs looking great. And this has been it can't be understood how important that those dividend payments are

to improving rrs. And that's really been one of the big drivers behind this. But that's actually frightening because it would suggest that the returns is meager as they have been, are also being juiced by tactics that may not be that are not sustainable. That's right, and hold periods. Actually this is interesting. So the underage Slifer, who is the most cited financial economist I think ever, and he says, there are three ingredients to a financial crisis. It's consensus, leverage,

and illiquidity, and those are the dangerous trio. And obviously, you know we have consensus here, we have increasing leverage, and what's really scary is the illiquidity aspect of this. So one of the ways the private equity firms, you can think about measuring private equities, how long is the average hold period? So they buy company and then they sell it, and I think in O five and oh six is average hold here is about three or four years, right, So they buy it, sell it in three or four years.

Now the genius to fix it in the music, right, they could do it that quickly. Now it's six or seven years. Okay, So these investments have gotten a lot more a liquid So that's another reason they're taking the dividends out and they're actually holding them longer. So why are they holding them longer? I would argue they're holding the longer because they can't sell them. They can't sell them at a higher peru, right, Hence the illiquidity right.

Another interpretation, which they would say, is we're holding them longer because it just we're having such a wonderful operational impact that we realize that just within another two years, under our benevolent management, we could really turn the corner operationally. So you can choose which your explanation. But I'm a cynic. What can I say? Hey, one of the things I find fascinating about you is that you're not criticizing from the outside. How did working at Bain helps shape your views?

And did you know when you went into Bain that you might become optic about private equity or did you go into it thinking this is the greatest thing ever. I'm going to be an operational genius who's going to help transform corporate America. Yeah. I did think of myself as a genius who is going to transform over to America's I think many twenty one year olds do. And I think that initially what attracted me to private equity was I think the same thing that attracts a lot

of investors to it. I thought, Okay, here's a chance to not only have the intellectual side of making investment decisions, figuring out what a good company is, or what a good industry is. But there's also this management. You know, you actually own the company, so you can make a difference and you can improve it. And wouldn't it be great if you could make money by doing both at the same time. And she look at the returns and everyone smart thinks this is a good idea. Right, Go

talk to any college endowment. What do they do? They think it's the best thing ever. And I was very persuaded by that. And I think that when I started doing more and more work, what I uncovered was not that anyone's intentions were bad. I think generally these are very smart, very well intentioned, good people, but that the prices for assets in the private market, we're going up

and up and up. And because the private equity models to lever everything at sixty five percent, if you go from paying seven times cash flow to ten times cash flow, that means you're going from putting four times cash flow of debt to six times cash flow of debt. Well, and then you go to twelve times fourteen times. You know, the higher you go, the more debt you're putting on it. And when I started to realize, we looked at a

huge data set of historic private equity deals. Was that those expensive deals, because of the large amounts of debt, had unusually high default rates and we're on unusually bad investments. That most of the money was made buying the cheaper investments right where you're putting a reasonable amount of debt on,

which seems logical to me. And this is also why people criticize financial engineering, because back in the eighties and nineties, financial engineering ment buying things really cheap and funding the purchase with debt, which I actually think is a great way to make money, right, you buy cheap things with debt makes a lot of sense. Expensive things with debt, right, like whether that's a yacht or a company or a diamond. You know, you know it's not going to work out

so well. And that's was very observable in the data. And when I started to see that data, I said, well, this doesn't really make sense to me. And that was in twenty eleven, twenty twelve. That was the moment of your conversion from the lever to skeptic. Well, and then since then purchase prices have gone up another twenty percent, So you know, I was skeptic probably too early, right, But things have only gotten crazier and debt levels only

gotten crazier. Why is it that, given that data doesn't usually lie well, I guess depends on how you interpret it. But the data seems so straightforward and so obvious in the logic seems so obvious. Buy something cheap, it's a lot easier to make money than if you buy something that's really expensive. Why won't the industry see it? I actually loved this statement that Bain made about your criticism

of the industry. Mister Asmussen was a junior member of our team during his employment without full insight into our investment process or operational value. Add Yes, I hope to meet someone with full insight someday, but I have with operational value speaking, I have cynicism value. Add perhaps that I think I think that's a better thing. But I think that there are a few things have gone on. Right. One is this lack of defaults. So's there have been

an unusually low rate of defaults over the past decade. Right, So, bad lending behavior has not been punished. Okay, buying really junky private credit assets has done. Okay, it's done. Okay, it hasn't defaulted. And because so much more of it is in private hands. The private people don't have as much of an incentive to push stuff into bankruptcy. It's not as visible when credit and stats are deteriorating. There's this extend and pertend philosophy. So because of that, the

bad things in private equity portfolios have not gone belly up. Now. There have been a few public exceptions, right, which we can talk about, ye, a few of the big public exceptions, but a lot of them have become sort of what I would call zombies. Right. These are the firms that are dragging the whole periods longer and longer. Right, So they don't default, they don't go bankrup they just stay

in the portfolio. Right. I even heard one large private equity manager come out and say, the thing I'm most proud of about my firm is that we've never lost money on an investment. Right. Amazing. And I said, well, what percent of the companies that you've ever bought do you currently own? And he said about sixty five percent.

I don't believe you've never acknowledged that you've lost money on investment, right, Right, But private markets allow you to do this, right, so you can hold on longer than the equivalent public asset, you don't have to pay the piper, and in time of low defaults, you really don't have

to pay the piper. And then if you look at what's happened in the public markets, that there's been a huge premium for growth, right, So anything with high revenue growth, high sales growth has done really well and has been valued it really insanely high prices. So you've had a corner of the portfolio, which is the very expensive but very high growth things that actually have been great investments. Right, You've been able to buy them at a really high price to flip them in your sale for a period

of time, and so you've got this contradictory lesson. Right on the one hand, you're saying, look all the stuff I paid crazy prices for I sold two years later for an even crazier price, and look how much money I made. And then yeah, I paid some high prices for some other stuff. But you know it's still marked at one and you know, our operational guys tell me that next year it's going to turn the corner and put up that up for market. Who knows what it's

going to be worth. So it's a bit of a version of check prints the former CEO of City Group who said famously, right before the financial crisis broke wide open, as long as the music's playing, you have to keep dancing. Yes, what's scary is to see these metrics, whether that's fundraising metrics, So more money being raised, more dry powder, which leads to higher purchase prices, which means to higher debt levels, which means to lower credit quality of either debt that's issued,

which leads to longer hold periods. Right, every single one of these metrics is deteriorating. There's not one that's not getting worse. But it's all driven by fundraising. So despite this, right, the fundraising is going in exactly the wrong direction. It is actually causing a lot of this bad behavior. Because I think people often talk about they say, well, look there are five hundred companies in the five but there are thirty thousand or one hundred thousand small companies in

the US. They're ripe for private equities, so it's a much better market. But what they don't realize is that it's a power law distribution, just like income. Right, Like Amazon is worth ten thousand small companies, right, So the actual market is much much bigger for these big liquid companies and small companies, and yet the amount of capital that's now chasing these tiny little companies is really overwhelming

that market. And I think you've quoted or at least you've heard some private equity officials themselves expressing concerns about this, worries about the sheer amount of money that needs to be invested, but yet they don't stop. Yeah, well yeah, I mean it is funny. I had at one point I should find a series of quotes from KKR, Apollo, Carlyle Blackstone, the heads of all these firms, saying this is the hardest time it's ever been to invest. Our

Number one problem is high purchase prices. What's going on in the debt markets isn't sane. I mean, they're very open about it, they see it, and yet they're raising bigger and bigger funds. And as some component of that, not just their own belief in their own brilliance, but also the fact that they're paid a management fee upon

those assets. So there's an incentive for asset gathering as opposed to I mean, at what point, even with a giant firm, does the incentive for asset gathering become become more compelling than the incentive to to make good investments. I don't even think it's it's them driving it. I mean they're the beneficiaries of a massive wave. They couldn't stop raising money if they tried. I mean I talked to so many pension fund managers and endowment manages and I say the same things. I said, Yes, why are

you doing this? You know, why don't you just press pause for a little bit. And one of the things I say was, well, she if we don't commit to fund six, we're never going to be let into fund seven. Right, So there's this It's not only fear of missing out, it's fear of being locked out because right, because you didn't stick with them for every single fund and so and then they say, well, and markets have been going amps.

If we want to maintain a steady allocation to private equity and this public markets went up twenty percent, we need to increase our allocation private equity by twenty percent versus what we committed to the last fund. Right. So they're going to their managers and they're saying, we need I know, you took one hundred million last time, it can you take two hundred million this cycle, and which private equity guy is going to say, well, no, we

you know, it's really not a good time in the cycle. Right, They're going to say, oh, right, you want me to manage four billion and so of two billions, so you're a double my salary. You're almost making less. Say no, you're almost making me feel bad. For these poor private equity guys with all of these billions of dollars being thrown at them, I mean, they're just helpless in the

face of it. Who could resist. One of the criticisms I've heard of your work or your theory comes down to this, which is that private equity may be dangerous, but public markets are way more dangerous. How would you respond to that? Yeah, I think public markets are more volatile, right, so they feel more dangerous right where they or they look, the volatility is more obvious or more real and right,

and that also enables bad behavior. Right, that's very easy to sell at the bottom and buy at the top and right, whereas private equit at least you're locking up your capital into something for a long period of time and you literally can't sell it. So maybe that's a good thing. But I think when I think about risk, I think about two primary forms of risk. One is valuation risk, so are you just paying too much given what an asset has been worth historically or relative to

other assets? And then I think second is credit risk, so is what you're buying going to go bankrupt? Right? So two very simple ways of thinking about it. So for public markets, right, you could say, is their valuation risk? Yes? In the US, yes, stocks are priced expensively relative to long history, but probably not so much bankruptcy risk, but not bankruptcy risks there's not a lot of debt. Right, Is Apple or Amazon or Facebook going to go bankrupt? No? Right,

they don't have a lot of debt. They're not going to go bankrupt. What's different with private companies? Right? Private companies are a lot smaller. So the average private company is actually about one tenth the size in terms of market cap as the average Russell two thousand small cap companies. So these are tiny, tiny little companies, and they're tiny little companies that have probably about three to six times as much debt on them as the average public company,

which is ten times bigger. Right, Right, So you're looking at these tiny, tiny companies that are much much more levered, and they're trading at prices that are twenty percent higher than oh seven, I don't know. Both those things line up for me, and I say, look, is it historically risky as measured by historical volatility? No? Is it risky as measured by the performance historically No? Both those things

suggest it's the best thing since slice bread. You shoul put one hundred percent of your money in next it's perfectly it's less volatile than bonds and as higher turns than equities. But any prospective analysis that looks at okay, but what are they actually buying? Right? That's what's scary, right.

And it's so interesting because going back to your point about statistics, even if statistics often do tell the right story, you have to be very careful about what statistics you choose to look at, because the narrative you want to hear can influence the statistics you choose to see. Right, how dangerous is this is? I listen to that, I think, Okay, well, the debt figures are really really frightening. At the same time, if these are really really small companies, how much damage

does this do? If you're right in the bankruptcy risk is big? How much damage does this do to the financial system? The interesting thing about it, and part of this was created by the FED saying, hey, this shouldn't be done at banks, right, this should be done by these private lenders and BDC. Did the FED actually say that or did they just say this shouldn't be done at banks without meaning right, right? Right? Right? Instead? Uh?

And so I think the impact on the economy, right, So I think on the one hand, i'd say, look, it's small, right, It really is a small It's a drop in the bucket. But ben Burnank wrote his PhD thesis on the small shocks big crises puzzle, right, So small shocks calls big crises with some level of regular some extent, right, And so I would say, look, is it a tiny thing. We're alter the size of the economy. Yes? Could it have an out sized impact if it impacts

how market participants act? Yes, Now where will the pain be felt the most? I would say, I don't know if it'll affect the economy. I don't know if it'll affect the broader market, right, I do know it'll affect people that own it, Okay, And who owns it? Pension funds, pension funds and college endowments, some of whom are putting thirty forty at the upper end percent of their money

into private markets, private equity, private debt, venture capital. Right, I mean because of this institutional consensus, right, And I think those are the people that are going to get whacked by this, people who can least afford it, at least in the case of pension funds. So it's right, right. Do you think anybody understands given that the financing side of this, the debt provision side of this, has become so opaque, do you think there's anybody who understands what

goes on there? Is it possible to figure that out? I think there certainly are the problems. There's no way to short it, right, it's all private, yea. How do you short science private? You can't, So there's no you know, there's no gym. We don't have a big short yet. Right,

You can't really short it. All you can do is say, gee, you know, I think you're a little crazy to be putting money there, and then the person goes back to and so public markets are down twenty last year and our private equity port flows down five So you're the crazy one, right, right. Is there any irony in the fact that the very private equity firms that talk up the benefits of private investing Blackstone, KKR, Apollo are themselves

publicly traded. It is remarkable, isn't it. I'm not sure you'd think they could go private and then improve themselves.

Maybe that's what we'll recommend that. Maybe that's what we'll get to actually, as when the private equity firms start taking each other private in order to operationally improve themselves, and then all the workers there, all the brilliant Harvard MBAs, can figure out what it feels like to be a line on right, and I'll reveal to them that their models aren't very accurate, so they probably could use about fifty percent fewer analysts exactly. Now, that would be a

perfect fictional ending about all this. So if you had to predict this, does this end in a bloodbath? Are just in disappointment and slow, sad disappointment for the pension funds, as we've discussed, who need these returns the most. I think it really depends on whether we have a default cycle or not. So if we have a real default cycle, like we had No Three, then this thing blows up right,

because all these things are not credit worthy. I mean, and so if there's any change in credit standards from extremely loose to somewhat reasonable, a huge percentage of this stuff, you know, I'd say upwards of thirty percent of private equity deals, and my guess would be going to default.

This stuff is really bad paper. However, standing number, I think zombification is a real alternative, right, which is that we just extend and pretend, right, so it just fizzles and all of a sudden, you've got a fifteen year old private equity fund that still has three investments that are still marked at one that just hasn't sold, and you're disappointed, but the rr still looks good because some of the dividend recaps early on, right, I mean, I

think that's a really good and frightening phrase. Just tell us quickly what you're trying to do with for dad. My premise is that if you look at the early years of private equity, the returns really were wonderful during the financial engineering years, and there the two key ingredients to that. We're buying cheap companies and they were using debt to fund the purchases they got. When the investments

went well. They went well, really well, because they were levered, And my logic is, why not just copy that strategy but do it in public markets. So go and find small cap companies all over the world that are trading at prices that look like nineteen eighties or nineteen nineties

private equity, and that have similar capital structures. They're nicely levered, and so you get that extra juice and the returns, and so my ideas, let's profit from what private equity used to do, which is sort of ironic even that I'm such a critic of the industry, I'm not a critic of what they used to do. I thought that was brilliant, and I think that's what David Swinson fell in love with, and I think a lot of other

people did. It's what they're doing now, which I think actually bears very little resemblance what they were doing twenty years ago. Funny how things can mutate under our noses without us realizing that they've mutated, because we're still clinging to a version of the past that doesn't exist anymore. Financial markets, i think, are the place where that happens most often, because we always invest in the thing that's done well historically and by nature of people agreeing that

it's a good idea, it becomes a bad idea. We are pack creatures and emotional creatures at the end of the day, right, Thank you so much for being here with me. This was really fun, my pleasure. I was struck by how much my conversation with Danielle wasn't just about the metrics and details of investing, and of course there was plenty of that, but rather about human nature. Why is it that we can know the present is different from the past, yet cling to the past anyway.

Why is it that we become victims of our own success. Why do we prefer narrative to numbers, or choose the numbers that we want to support the narrative that's most convenient. On a more practical level, I also came away from this conversation quite concerned. One impetus for the devastating two thousand and eight global financial crisis was something called the shadow banking system, the buildup of debt in all these

places that regulators didn't see and couldn't control. I didn't realize we were creating another shadow banking system with all the debt from private equity deals. I have a hard time believing this plays out well. Not for our markets, but certainly not for the pension funds who are depending on private equity to bail them out. Making a Killing is a co production of Pushkin Industries and Chalk and Blade. It's produced by Ruth Barnes and Rosie Stoffer. My executive

producers are Alison mcclein. No relation in Making Casey. The executive producer at Pushkin is Mia Loebell. Engineering by Jason Gambrell and Jason Rostkowski. Our music is by Jed Flood. Special thanks to Jacob Weisberg at Pushkin and everyone on the show. I'm Bethany McClain. Thank you so much for listening. You can find me on Twitter at Bethany mac twelve and let me know which episodes you've most enjoyed.