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