The following is a partial transcript of an interview given by Verdad Capital’s Dan Rasmussen to Dan Lefkoviz for Morningstar’s Long View podcast.
Lefkovitz: You worked in the private equity space as an investor, but you write in your book that private equity is the single biggest mistake that investors are making in markets today. Could you explain what you mean?
Rasmussen: I think that one of the elements of meta-analysis is to look for correlated beliefs. Places where everybody seems to agree, but where they might not be right, and where maybe logic and first principle suggests that they aren’t right. Private equity is a place where, if you think about the profit share of private equity companies, the share of the total aggregate profit created by private firms relative to publicly listed firms, they’re probably about 2% to 4% of the aggregate profit pool. Right now, private equity folks will always say, well, there are huge infinite number of private companies and very few public companies. And so the opportunity set is much bigger outside of the public markets. The problem with that is that the private companies are much, much, much smaller than public companies. Yes, there are thousands and thousands of dry cleaners. But add up all the dry cleaners in the world and you don’t even get to one Facebook.
So, the number of companies doesn’t matter. It’s the aggregate profit share. And that’s again, quite small. Private equity deals are micro caps generally. The median market cap is less than $200 million, about $180 million. And again, micro caps as a corner of the public equity market are tiny, tiny, tiny. Single-digit percentages. And yet you’re seeing very sophisticated investors—endowments, foundations, even pension funds—putting 40% of their money in private markets. This is a massive, massive overweight of micro-cap companies in their portfolios. So first of all, there’s a flood of money, an excessive amount of money relative to the opportunity set flowing into this space. The second part is around risk. If there’s one thing we know about really small companies, It is that they’re distinctly more risky than large companies. They’re more likely to go bankrupt. They’re less diversified. They’re more volatile. And the next thing that we know is that private equity deals are leveraged. They borrow a lot of money.
And so, you’re looking at leveraged companies, very leveraged companies that are very small. You’re looking at a very, very, very risky set of companies. And so to take 40% of your portfolio and put it in these very small, very leveraged, very risky companies is a very, very risky decision. Now, if you’re going to take that risky decision, you must have a view that private equity is going to somehow dramatically outperform public equity markets for you to take on this incremental risk. And by the way, incremental illiquidity. But I would argue that it’s unreasonable to have that assumption for a few reasons. I think one is that the valuations today in private equity are actually higher than public markets. It doesn’t always look like that from the statistics, but what the statistics that are quoted are often missing is that private equity reports pro forma numbers, pro forma, EBITDA. Pro forma EBITDA is often very different from GAAP if there was a GAAP concept of EBITDA, but the way public companies would calculate EBITDA. And so those adjustments are often about a third of the difference.
What you’re seeing is these very inflated valuations in private markets funded by massive amounts of borrowing from private credit. Allocators putting huge percentages of their endowments or pension funds into this asset class. And by the way, they’re doing so at very high fees and with illiquidity. My view is that that’s the tremendous amount of correlated risk. Everybody’s doing it. Everybody’s doing it in way bigger proportion than the actual economic substance of what they’re investing in would justify, all with the same correlated belief that private equity will outperform. And I think it’s not going to end well. Debt-fueled, illiquid asset over allocation rarely does. And this is, I think, one of the biggest risks that large, sophisticated investors face today.
Lefkovitz: What about the trend that so much capital formation is happening in private markets these days? We have all these unicorns that are staying private for so long. And so much of their growth is happening off of public markets. And so investors just to get exposure to the entire opportunity set need to include private markets.
Rasmussen: Yeah, again, it’s often pitched that way. But as a percentage of the actual amount of profits or even revenue in the economy, it’s very, very small. So yes, they’re salient examples. There are few of these companies that stay private for very long periods of time. But for every one of those, there are often unicorns that lose their horns or whatever that you don’t hear about that seemed like they were going to become massive winners that go bankrupt or whatever it might be. Those salient examples are often lost. And so I think that people have to be very, very wary of these illiquid asset classes and make the meta-analytic judgment of why this opportunity is so much better than public markets to justify the fees and the illiquidity. If your answer is that the markets are less efficient, well, I’m sorry, if everybody’s putting 40% of their money into this, it’s not inefficient. Or if your argument is that private equity operators improve the companies they own, well, 40 or 50% of deals are sponsor to sponsor. So if BlackRock didn’t and Blackstone didn’t improve it, when KKR buys it from them, they’re going to improve it again.
How could this kind of constant improvement be some constant edge for the asset class? I think a lot of these stories are concealing the realities that this is leveraged microcap and technology these days. It’s very heavily technology focused, leveraged microcap tech investing in an asset class that has seen massive inflows. And by the way, those inflows seem to have stopped. All the tailwinds from the increased fundraising, at least for now, seem on pause. And what you’re seeing is that it’s also very, very hard to exit. These companies are having a lot of trouble selling their portfolio companies, probably because they’re not getting the valuations they want from them. Or the public markets don’t like companies that are 8x leveraged or whatever these companies are. And so all those, I think, point to a moment where private equity, probably since the financial crisis has been roughly equal to the S&P 500’s returns over the last two or three years, however, you’ve started to see the S&P have higher returns.
So those endowments that chose not to have large private allocations have been doing better. And so you’ll start to see people wondering why did I take on this illiquidity risk? Why am I paying these fees for something that’s not outperforming the public equity markets? And when the fund inflows turn to fund outflows, everything in financial markets is recursive. It’s going to have a very negative impact on the asset class.
Lefkovitz: And you mentioned private credit. This is a really hot asset class these days, but you call private credit fools’ yield. Why do you characterize it that way?
Rasmussen: So markets are efficient. We need to have a healthy respect for efficient markets. And so you have to ask yourself, why do Treasuries have a 4% yield and private credit has a 10% or 12% yield? What’s the reason? And the reason is that the only thing that incremental yield can be pricing is bankruptcy risk, the risk of nonrepayment. And so private credit is making an interesting marketing pitch. They’re saying, on the one hand, we earn higher yields. And then on the other hand, they’re saying, but default risk is very low. We’re going to say, well, if default risk was very low, why wouldn’t you lend money at 5% instead of 12%? Surely these borrowers, if they were so high quality, and so unlikely to default, could access capital markets at much lower yields. Because the only thing really that yield can be pricing is default risk. And I think that what I would argue is that yields are actually a very efficient way of pricing default risk, that lending markets have been around as long as humans have been around.
There are wonderful series, like Moody’s hasgreat lending data back to like the 1920s, where you can see the default rates of all different companies by every different statistic. So the idea that pricing the yield at which you should lend to a company is a new field, or that there’s been innovations, is probably hubris. And rather, we should have a healthy respect that most likely yields are efficiently pricing default rates. What we’ve actually found by looking over the last, call it 30 years of market history, is that yields are not returns. Returns are yields minus default rates. What you’ve seen is that as you go from AAA, Treasuries up to about BB bonds, sort of a fallen angel range, where a company like Ford, for example, today might sit. As yields go up, returns also go up. So realized returns are higher for BBB corporates than for US treasuries over long periods of time. You’re earning some incremental risk by taking on corporate credit risk, which makes sense.
But after about that BB point, yields go up and returns go down, because essentially, people don’t really have as good of a handle, 25% yield. It’s very hard to price the default risk. You’re just sort of saying, well, it’s a really high default risk. So I really need a really high yield. But it ends up being that most often the default rates exceed that money. And part of it is people are just attracted to high yields. They think they’re going to earn it, which is why I call it fool’s yield. And there are enough idiots that are willing to lend at that rate that it pulls down the end total returns. And you can see this across so many wonderful examples like lending club, where people were lending at 25% yields and earning 5% results, where they could have lent at 5.5% to GM and earned 5.5% back, rather than lending at 25 and getting a 5% return.
I think the problem with private credit is that I think it’s a classic case of fool’s yield. These are risky borrowers. You just haven’t realised the risk yet. And when you do, you’re going to do it all at the same time, which is what happens in default cycles. You’re going to realise why all of these companies had to borrow at 12%. The sort of a Venn diagram of high-quality companies that are never going to go bankrupt and companies that have to borrow at 12% is virtually non-existent. And that’s because again, lending is such an efficient market. And of course, the private credit folks are telling you this themselves in some sense. They’re saying, well, the banks thought this was too risky. And I sort of say, well, if the banks thought it was too risky, it’s not like those guys at Goldman are shrinking away from great profit opportunities. There must have been reason they thought it was too risky and most likely it’s that the banks had been around for a few cycles and private credit really emerged after the big financial crisis.
This was a snippet from Dan Rasmussen’s appearance on Morningstar’s Long View podcast. You can find the full episode here.
Daniel Rasmussen is the founder and managing partner of global asset management firm, Verdad Advisers. Nothing contained in this article constitutes investment, legal, tax or other advice, nor is it to be relied upon in making any investment or other decisions. You should seek professional advice prior to making any investment decisions.