For decades, private equity has been the darling of pension funds, university endowments, and sovereign wealth funds, promising high returns and low volatility. Now, President Donald Trump has made it possible for everyday investors to get in on the magic with his executive order, "Democratizing Access to Alternative Assets for 401(k) Investors.” The order relieves regulatory burdens that limit the access of defined contribution plans, like 401(k)s, to alternative assets such as private equity (but also cryptocurrency and real estate). The hope is to give American workers access to greater choice, diversification, and potential growth towards a comfortable retirement. But Trump's order comes just as longstanding questions about private equity’s promise of high returns and low risk are coming to the fore. Has the distribution of returns slowed to a trickle? What does data actually say about private equity’s performance, and where is the industry headed? There is also a long standing debate whether private equity is good for society, independent of financial returns. Is private equity actually a ponzi scheme that now threatens the retirements of millions of American workers? To make sense of it all, Luigi and Bethany are joined by Dan Rasmussen, an experienced investor and author who began his career in private equity but has emerged as one of the most prescient critics of the industry. Together, the three of them distill what the state of the industry means for the future welfare of investors, workers, and the American economy as a whole.
For decades, private equity has been the darling of pension funds, university endowments, and sovereign wealth funds, promising high returns and low volatility. Now, President Donald Trump has made it possible for everyday investors to get in on the magic with his executive order, "Democratizing Access to Alternative Assets for 401(k) Investors.” The order relieves regulatory burdens that limit the access of defined contribution plans, like 401(k)s, to alternative assets such as private equity (but also cryptocurrency and real estate). The hope is to give American workers access to greater choice, diversification, and potential growth towards a comfortable retirement.
But Trump's order comes just as longstanding questions about private equity’s promise of high returns and low risk are coming to the fore. Has the distribution of returns slowed to a trickle? What does data actually say about private equity’s performance, and where is the industry headed? There is also a long standing debate whether private equity is good for society, independent of financial returns.
Is private equity actually a ponzi scheme that now threatens the retirements of millions of American workers? To make sense of it all, Luigi and Bethany are joined by Dan Rasmussen, an experienced investor and author who began his career in private equity but has emerged as one of the most prescient critics of the industry. Together, the three of them distill what the state of the industry means for the future welfare of investors, workers, and the American economy as a whole.
Bonus: Check out ProMarket’s recent series on the impact of private equity in the health care industry.
Dan Rasmussen: The S&P 500 is at all-time highs, and the stock market is booming, and the economy seems to be booming, and for some reason, private equity can’t sell their deals. They can’t exit their deals. You’re like, “Well, if these companies are so, so good, why can’t you sell them? It seems like a good time to sell. It seems like the public markets are doing fine. The IPO market’s open. Maybe these companies just aren’t that good, or maybe they paid too-high prices for them.” That’s, I think, the sad truth here.
Bethany: I’m Bethany McLean.
Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?
Luigi: And I’m Luigi Zingales.
Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.
Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.
Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?
Luigi: And, most importantly, what isn’t.
Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.
Bethany: For decades, private equity was the darling of pension funds, university endowments, and sovereign-wealth funds. It promised high returns, low volatility, and maybe even better companies in the bargain. Now the Trump administration has just made it possible for ordinary investors to get some of the magic.
On August 7, Trump issued a presidential action entitled “Democratizing Access to Alternative Assets for 401(k) Investors.” His action went on to say, “My administration will relieve the regulatory burdens and litigation risk that impede American workers’ retirement accounts from achieving the competitive returns and asset diversification necessary to secure a dignified, comfortable retirement.”
Luigi, isn’t that exciting?
Luigi: You don’t need to be a psychologist to hear some sarcasm in your voice. But you’re right, the timing is a bit ironic, to say the least, because Trump’s rulings come just as long-standing questions about private equity are coming to the fore. Why have distributions slowed to a trickle, what do the data actually say about performance, and where is the industry headed?
Bethany: Let’s start with some context. In the early days, what were once called leveraged buyouts—I’ve never been able to figure out who had the idea to call it the far friendlier “private equity”—had a certain formula: small companies, low purchase multiples, some leverage, and a plan to grow.
Luigi: The combination produced big returns, in part because you were buying cheaply and adding the alchemy of debt on top, and in part because the market was expanding. More and more people were pouring money in, and so it was easy to raise funds and then to sell subsequently.
Bethany: Over time, though, the increased competition drove up prices. Private-equity firms started paying more and more for deals. For a long time, this didn’t seem to matter, in part because with interest rates near zero, the cost of debt was almost nothing, and private-equity firms could engage in financial engineering, like so-called dividend recapitalizations, in which the PE firm adds a slug to a company’s debt load and takes the money to pay itself a distribution.
There was also a blip after the global financial crisis, when it looked for a minute like private equity was in trouble when the markets plunged. But then the subsequent decline in asset prices resulted in a big new entry point for private equity to do deals on the cheap.
The problem is that price does matter. There’s a study by Bain showing that half of deals done at more than 10 times EBITDA—EBITDA, for those of you who aren’t finance people, is a measure of cash flow—generated a zero net internal rate of return.
Luigi: Indeed, over the years, the criticism of private equity has grown. There is a debate about how big the returns actually are. We did an episode back in early 2022 that—spoiler alert—didn’t get a satisfying answer, particularly if you take out the benefit of leverage.
The returns also look far less good if you take out the early years, and there are a lot of questions about whether private-equity funds really value their holdings appropriately.
And, of course, there is a huge debate about whether private equity is good for society, independent of the returns, because you can earn a lot of money and create a lot of externalities that make society worse off. This would really be an example of capitalisn’t.
Bethany: Despite all of this, the money kept flowing in. Today, private-equity assets under management top $4 trillion globally.
The industry does now seem to be at, well, maybe not a crisis point—if you’re a cynic, it would explain why PE firms have lobbied so hard to get their hands on your money—but definitely a turning point.
One of the big stories right now is that distributions—cash returns to investors—have slowed dramatically. Since 2018, capital calls, meaning the amount of money that investors are putting in, have outpaced distributions, the amount they’re getting out, by about $1.5 trillion.
If you’re a pension fund counting on those distributions to meet obligations, or now a college endowment counting on those distributions to fund something, that’s fast becoming a big problem.
Luigi: It looks like it’s not just temporary. For vintage 2021 funds, distributions are down 80 percent vis-à-vis the historical norms. For 2019 and 2020, they’re down 40 percent and 30 percent, respectively.
It’s a reminder that these are very illiquid investments. You can’t just get your money out by selling your shares at the drop of a hat. So private-equity firms have increasingly resorted to tactics like so-called continuation funds, in which they create new funds to buy the assets of the old funds.
In terms of context, I used to teach this stuff, and I remember they had some provision to prohibit this, specifically because continuation funds were absolutely considered a no-no, but now they seem to be becoming the norm.
Bethany: This whole thing does sound Ponzi-ish to me, but instead of me just sounding off, let’s talk to someone far more knowledgeable.
Dan Rasmussen, who began his career in private equity inside the belly of the beast—he worked for Bain—has emerged as one of the most prescient critics of the industry.
In a recent piece for the Financial Times, he wrote this: “The consensus on private equity is being quietly but decisively written. The question now is not whether the model is being broken. It’s whether the exit is wide enough for everyone trying to leave.”
Dan is also the founder of Verdad Advisers, an investment firm with over $1 billion under management, and he’s the author of The Humble Investor and American Uprising. We’re delighted to welcome him to Capitalisn’t.
To start at the very beginning, what is it that made you start investigating private equity?
Dan Rasmussen: My first job out of college was working in private equity, so I spent four years in the industry and got assigned to look at what had happened during the financial crisis and what had worked and not worked in private equity.
I started looking at private equity from a quantitative angle. It was a fascinating project. There were three big insights from that early project.
First, private-equity deals are really small relative to the scale of public-equity markets. To frame this in terms of numbers, you think of the S&P 500 having a market cap of about $50 trillion, so 500 companies, about $50 trillion in market cap.
The Russell 2000, which is four times as many companies, the small-cap index, has a market cap of about $2 trillion. For private equity, there are about 12,000 private-equity-backed companies, and the market cap of all those is about $2.4 trillion.
The second thing is that these tiny companies . . . The origin of private equity—they used to call it leveraged buyouts—is using debt to buy companies. These companies are not only very small, but they’re very levered. When you contextualize that with the public markets, the S&P 500 companies are barely levered at all. Apple has cash, not debt. But the typical private-equity-backed company is about 60 percent debt financed.
You back into these numbers by looking at the size of the private credit market, which is about $3 trillion, so it’s bigger than the private-equity market now, and that roughly parallels. You have $2 trillion of equity and $3 trillion of debt sitting on top of these 12,000 really small companies, and that’s the private-equity asset class.
The third insight from the study was comparing valuation multiples and saying, how much do you pay for one of these small, private companies, and how much do you pay for a public company?
For 20 years or so, from the ’80s until the early 2000s, private equity was buying companies at about a 40 percent discount to the public markets, which makes sense. You’re buying a tiny, subscale company that is not big enough to have caught the attention of other people. You should pay a lower price for it. You’re paying an illiquidity discount, which is how you earn your illiquidity premium, and then you could go and sell it.
For the good ones, you could sell to a strategic for a higher valuation, or you could IPO them at a higher valuation, and there was this natural process. If you were really good, and you got one of your guys promoted from the minor leagues to the major leagues, you made a lot of money. That was the model.
Probably in 2005-06, right before the financial crisis, what happened is that private equity started to get more popular, and deal valuations started to converge. Instead of paying that 40 percent discount, all of a sudden, you were starting to pay, actually, quite normal prices for private businesses, not those cheap bargains that you had before.
Then, post-2010 and really in the last 15 years, you’ve seen private-equity valuations go through the roof to where it’s more expensive to buy a private company than it is to buy a public company because every company is going up for auction, and there are 20 or 50 or 100 bidders because everybody and their mother is a private-equity firm now.
Again, if you take that $2 trillion number, relative to $50 trillion for the S&P 500, you come to a sense of, OK, if I’m index weighting, I should have about 4 percent of my US public-equity allocation in private equity—something like that, 4 or 5 percent. If I’m 60-40 stocks to bonds, then maybe I should have 3 percent of my overall portfolio in private equity.
But you look at what the “smartest people in the room” are doing, and they’re putting 40 percent, 45 percent, 50 percent of their portfolios in private equity. You look at Yale, Harvard, Brown. By the way, if you go down the top 10 college endowments and look at what percent they have in private equity, it’s all like 40 percent. There are no outliers; there’s no divergence. It is complete consensus groupthink that you should have 40 or 50 percent of your money in these tiny, tiny, little, really levered companies. How everybody came to that conclusion, and why there’s no disagreement, I don’t know, but it is true.
I think the basic logic and facts . . . When you hear why all this money has been going into this tiny set of tiny companies, and you try to figure out how people are going to make money off it, you’re like, “Well, why am I going to earn such higher returns by paying 2-and-20 fees to buy tiny, little companies at higher prices than public markets, using a lot of debt, when those companies are mostly small and low margin?”
People talk about foreign stocks, and they say, “Well, I don’t want to invest in Europe because there’s no European Google, and there’s no European Nvidia.” It’s like, well, there’s no private Nvidia; there’s no private Google. So why are you putting 40 percent of your money in privates? These are subscale, relatively crappy companies, and yet, investing massively overweight to this stuff is the best idea that all of our smart allocator friends have had.
Luigi: Let me play the devil’s advocate. I think if you are Yale, or if you are a large endowment, you don’t have any comparative advantage in investing in the public market, but you have two comparative advantages investing in private markets, although one is disappearing.
The first one is that you’re not supposed to have any major shocks. Before Trump, universities did not have any liquidity shocks, and so they could afford to lock in capital for 10 years. That’s one source of comparative advantage.
Second, they actually know the alumni very well. It’s very difficult to sell information. I know you are a student of Ken Arrow, who was the first one to point out this fact, that it’s difficult to sell information.
However, if you are an alum, you can pretty easily donate information to your alma mater. And, by the way, there is a level of trust. The comparative advantage of endowments is precisely to invest in private equity.
What I don’t understand, which we’re going to come later, is why I would have individuals invest in private equity. But that’s a separate thing. Maybe 40 percent is overdoing it, but at least historically, I saw a reason why they were overweighting that particular segment.
Dan Rasmussen: I think there are two ideas here. The first is the idea that you should get paid for taking on illiquidity, and the second is that you should get paid for superior managerial skill and—
Luigi: Or picking good managers or having the information to pick good managers.
Dan Rasmussen: For the first, my argument would be that to earn an illiquidity premium, you have to purchase at an illiquidity discount. You can’t pay more than the public markets for the asset and then expect to earn an illiquidity premium. You paid a premium to buy the asset. Where’s the discount? I think it’s really hard to argue that you’re getting a discount in private markets today. There are just too many private-equity firms.
Luigi: But Dan, do you really believe the accounting numbers of private firms? Maybe it’s because of my Italian origins, but when you buy from an owner, the owner does everything possible to hide the earnings, right?
Dan Rasmussen: Yeah. But there are a lot of studies by S&P and others that the adjusted EBITDA numbers that private equity assigns to these companies and the models that they use to underwrite their deals tend to be about 30 percent higher than what actually occurs. So there’s about 30 percent of these add-backs that are phantom.
I’d actually argue that there’s a massive overstatement of EBITDA by private-equity firms relative to the true cash economics of these businesses. You’re adding back all this stuff, and then you’re paying quite a premium price. It’s basic auction math. You only need two parties at an auction to have an efficient market. If you have 17 parties, what’s the case that one of them is just kind of crazy or desperate? I think that’s the state of private equity today.
Talk to any mid-market private-equity firm and say: “Tell us about the last 15 sale processes you were in. Were they competitive or not competitive?” They’ll tell you it’s crazy competitive. There are way too many private-equity firms, and that’s not a recipe for buying things at a discount.
If you’re not buying at a discount, how do you earn a premium? You’re in the most overheated, overbought market there is. You’re not getting any bargains, and you have to get a bargain to earn a premium. Yes, great, you have a long view, but that doesn’t necessarily get you anything, unless someone’s willing to pay you for it, and they’re not.
The next thing about managerial skill is the same argument that would apply to active public-equity management. Couldn’t you figure out who the best guy at Fidelity was because he went to your alma mater, and he calls and tells you? Why is it necessary that you do that in private markets? You could do it in public markets, too. You could know that Ken Griffin’s a really smart guy and invests in Citadel. I don’t think that necessitates a shift from public to private or it necessitates any specific asset class just to choose the best people.
I think the only argument that private markets might offer in that regard is the idea that these private-equity owners are improving the companies that they buy, that they’re running them better than other comparable people, and that the source of alpha in private equity is operational improvement. I have a very healthy skepticism of that idea.
Bethany: Talk a little bit more about that skepticism of the idea that private equity is delivering operational improvements because it’s documented skepticism. It’s not simply my form of skepticism, which is opinion-based skepticism. That was the first study of yours that I had come across years ago.
Dan Rasmussen: I like to start with, again, basic common sense. Who do the private-equity firms hire? It turns out they hire a bunch of investment bankers. Then you say, “Well, where in your investment-banking career did you suddenly learn to run Midwestern industrial businesses?” If operational improvement was the key driver, why don’t they hire a bunch of ex-CEOs to run these companies, or ex-middle managers or sourcing people?
In fact, those people are like a serf class within private equity. They’re in the portfolio group. All the partners are the deal guys. What are they good at? They’re doing deals. It’s not about operational improvements and never was, except as marketing.
The way I’ve tried to document this is looking at some portion—a smaller portion these days, but a larger portion historically—of private-equity deals that issue public debt at the time that they do a deal. When you issue public debt, you have to report the last three years of GAAP financials. Then every year that the debt is live and paying a coupon, you have to issue the financials to your bondholders. That public data is available for a subset of LBOs that issue public debt.
You can look at these and say, “What did the pre-transaction economics look like, and what do the post-transaction economics look like?” You can control for sector and do this in a pretty robust way, which is what I did.
What you find is that revenue growth slows a little bit. My thesis for that is that private-equity firms tend to buy things that look like they’re high growth, but growth follows a random walk. So you buy stuff with high growth, and then it follows a random walk, and you end up with a little lower growth than you bought it at. Margins, basically flat. But you see a massive increase in debt and interest payments and a decrease in capex spending.
I think that’s intuitive. It’s an LBO. What do you expect? The reason they took control of the company is to increase the debt. What happens in every LBO is an increase in debt. What happens in some LBOs might be an increase in margins, and in another, a decrease in margins. Some revenue growth increases, but there’s no reason, systematically, to think that private equity qua private equity is better at running companies than public-company CEOs or families or any other group of people.
Otherwise, why wouldn’t Harvard in their MBA program teach a whole class on the private-equity cookbook, how to run companies like Blackstone? Because there isn’t a cookbook. It’s just a bunch of investment bankers that buy companies and then sit on the board and yell at people to make the finances better.
Luigi: I don’t know how familiar you are with publicly traded companies. There are plenty of inefficiencies. It’s not that they’re perfectly run. And so, I can see that having somebody with the right incentives sitting on top of a competent manager . . . I think you mischaracterize this a bit in the sense that companies are run by proficient managers. You call them serfs, but they make a lot of money, so they’re not really exploited as serfs.
The only thing that the LBO organizations do—and then there is a question why they pay so much for it—is maintain some financial discipline and allow the firm to carry a huge amount of debt. Even after the tax reform, debt is tax favored. Before, it was even more. You might argue that this is bad for society, but that’s the fault of Congress for having favored that.
There’s a huge advantage of having debt from a tax point of view. The cost of having this debt is that when the proverbial s--- hits the fan, you find it difficult to raise funds. If you have somebody on top of you who provides the funds in those moments because they know and trust you, then they allow you to run the company at a much, much higher leverage, which is, from a tax point of view, enormously efficient.
Dan Rasmussen: I’m sympathetic to that argument, Luigi, in that there’s no question, it’s very well-documented that private-equity-sponsored companies are able to access the debt markets in a much more effective and efficient way. They get better terms. They get more forbearance when things go badly. They’re able to take on more debt. They get treated better in restructurings.
I think that’s consistent with my view that what is the private-equity operational value-add? It’s that they are ex-investment bankers who, unsurprisingly, really know well how to do acquisitions and manage debt capital markets. I buy into that thesis completely, and I think that’s one of the good things about private equity.
However, as a class, private-equity-backed companies run at much lower margins at almost every level than public companies. They’re much lower margin. Part of that is structural. They’re tiny, little companies and less diversified, less scaled than public companies.
I think it’s hard to argue that they’re higher-quality companies. The highest-quality companies are obviously in public markets, and the higher-margin companies are in public markets. Yes, the private companies can be managed to hold a lot of debt, but that doesn’t make them better run, more efficient, higher-margin companies. They’re certainly not that.
It’s central to thinking about the private markets that debt in good times, in a market that’s going up, can be a lever to the upside. But when things go badly, obviously, it’s a tremendous problem to be very levered. You have a lot more downside risk, a lot higher bankruptcy, et cetera.
This brings us to this current moment, when the S&P 500 is at all-time highs, and the stock market is booming, and the economy seems to be booming, and for some reason, private equity can’t sell their deals. They can’t exit their deals. And you’re like, “Well, if these companies are so, so good, why can’t you sell them? It seems like a good time to sell. It seems like the public markets are doing fine. The IPO market’s open. Maybe these companies just aren’t that good, or maybe they paid too-high prices for them.” That’s, I think, the sad truth here.
Bethany: Let’s go to that. Maybe Luigi is right, and maybe private equity is the best thing ever, and these managers all deserve—
Luigi: I never said that. You’re mischaracterizing—
Bethany: And maybe I’m just a mean cynic who doesn’t like private equity. Let’s put all that aside. Regardless of whether it’s good or bad, we’re in this moment now when private equity can’t sell its deals, when the distributions aren’t coming back to the underlying investors. What’s happening? Talk us through the signs that you see of what’s happening to the industry right now.
Dan Rasmussen: Distribution to paid-in capital, DPI, is typically about 30 percent of NAV, or net asset value. You have $100 million invested every year, so you’re going to get back $30 million or so in aggregate. That’s dropped to $10 million. Distributions have just collapsed.
So you say, “Well, why have distributions collapsed?” To figure out that, you have to go and say, “Well, what are the traditional paths to exiting private-equity deals?” There are generally three paths. They’ve added a fourth, and we’ll talk about that.
The first, the biggest, is a sale to other private-equity firms. About 40 to 50 percent of private-equity exits are to other private-equity sponsors. Fundraising is down for the third year in a row. As long as the asset class is growing, you can always exit to somebody at a higher valuation. When the asset class starts shrinking, there’s pressure on that exit path.
The second is selling to strategics. There’s no reason that strategics wouldn’t be buying right now, other than that, for some reason, the assets were not the assets they wanted. Right now, there have not been a lot of strategic exits.
Third is IPOs. Generally, a small percentage of private-equity deals are big enough to IPO, but even those will IPO into the small-cap market. Basically, your buyer is the small-cap, active public-equity manager.
There are generally a few things about private-equity-backed IPOs that small-cap managers don’t like. One is that they tend to IPO, and then the private-equity sponsor still owns 70 or 80 percent of the equity, and they’re going to have to sell that down. You’re looking at this big overhang on the stock.
Second, it’s usually got a lot of debt. Public markets don’t love really levered firms for a whole variety of reasons, even though Luigi says they’re very much more efficient to run in a taxable way, but public-market investors hate them. The market votes no.
Third, do you know any small-cap, active public-equity managers? There aren’t that many left, and there are a lot of private-equity guys. So, there’s a lot of these and not that many of those. I think all of those have been under pressure.
What’s emerged as a result is a boom in the secondary market. People are selling their private-equity stakes to secondary firms, and the secondary firms love this because the accounting rules allow them to buy something at 70 or 80 cents on the dollar on Tuesday and mark it at $1 on a Wednesday because you don’t have to incorporate transactive values into your calculation of what a private-equity stake is worth. It’s always marked at NAV. You could even buy something at 10 cents on the dollar on Tuesday, and accounting rules allow you to mark it at $1 on a Wednesday. The private-equity secondary firms always look like they’re making money and earning an IRR. That’s become a very positive area of growth.
Then the private-equity firms themselves are doing continuation vehicles where they say: “We’re going to take this, and we’re going to sell it to another fund we control that’s dedicated to this thing or a group of these things. You can exit, or we’ll bring in new investors, and we’ll continue owning it because we can’t sell it to a third party.”
All of these things have emerged to fill the gap. But at the end of the day, there haven’t been enough of those to close this DPI gap that’s opened up of late.
Luigi: Again, I don’t want to be seen as defending private equity, but I’d like to play the devil’s-advocate role. At some level, you can argue, number one, our friend Lina Khan had a lot to do with the fact that strategic acquisitions are down. The way they were making money is by helping consolidating industries. Once you start to resurrect antitrust, that channel is down, for a good reason.
The second is that there’s a general downtrend in IPOs, and some people claim that the diffusion of indexing that we academics have pushed very hard has made it very difficult for new firms to come to market, and as a result, the IPO channel is down.
With fundraising, unfortunately, there is a bit of a Ponzi-scheme element in that. The more you can sell, the more you can raise; the more you can raise, the more you can sell, and so on and so forth.
Two, the attack on universities by Trump had a devastating effect on fundraising because Harvard needs to be very liquid. The last thing you want to do when you’re very liquid is to fund private equity. Of course, all the universities are being attacked at the same time, or they fear the threat of being attacked, and so the risk of a dramatic reduction in commitments is a reality because unfortunately, this market is becoming too dependent on university endowments and is suffering a big consequence. The combination of all three things together, happening at the same time, is really a big threat for the industry in this moment.
Bethany: But wasn’t fundraising down well before Trump came into office? Hasn’t it been falling for the last bunch of years?
Dan Rasmussen: Yeah, I think it fell in ’23 from ’22 and ’24 from ’23, and ’25 is down. It predated Trump, but Trump has definitely added to it.
But part of it was that distributions dried up even before Trump. Redeployed assets are always a big driver of the fundraising cycle. I got this back, and now I deploy it into your next fund. But for an asset class to be so dependent on flows isn’t good. If you need the asset class to grow, if fundraising needs to be good for your returns to be OK, that’s not necessarily a good thing.
Bethany: Am I wrong in thinking that it was a sign of problems to come that the volume of private-equity deals sold to other private-equity companies had been so high for such a long period of time? I want to say it peaked at around 45 percent back in 2022.
Isn’t that already a problem? Maybe I’m being too harsh, but isn’t it a problem if you don’t have an honest exit of being sold either to the public market because investors want this company or being sold to a strategic buyer because you’ve built such a good company that another strategic buyer wants it, and instead you have to sell to another private-equity firm? Or am I being too cynical?
Dan Rasmussen: The other way of looking at it is it’s interesting that private equity is offering the best price for these assets. What does that mean? By the way, if you think there’s operational improvement, and 45 percent of deals are sponsor to sponsor, does every private-equity firm improve it from the one before it, or does only the first one get the operational improvement? When does it happen, who captures the value, and doesn’t it challenge the thesis that operational improvement is what’s driving this if, in fact, most of these assets are flipped from sponsor to sponsor to sponsor?
Ultimately, the reason they sold was it was the best price, and it was the best price for two reasons. One, all the private-equity firms have raised a boatload of money, and two, private credit was willing to lend at ridiculous terms. And so, why not pay big prices?
Part of the reason that private-equity sponsors can’t pay as big prices now is because all the private-credit loans are floating rate. You’re getting materially worse terms in the debt because of the rise in interest rates. That’s pulling into valuations in a big way. Even though spreads have compressed, the underlying rise in rates has been really problematic.
Luigi: I saw in your newsletter, which is very interesting, some interesting analysis of publicly traded private-equity firms, particularly in England. You are making some interesting inferences about what it means for volatility, and so on and so forth.
One question that I had, when you look at one of them, the value of what you see traded is not just the value of the assets in place, but also the value of the future growth opportunities. When you see that they traded at a big discount to net asset value, it’s not just that the assets in place are not worth much. It is also the fact that you expect that the continuation value is very low.
If the industry is shrinking or does not have good prospects in the future, this will weigh down the valuation. All the volatility and all these things are impacted by these future opportunities that have not nothing to do with, but relatively little to do with the assets-in-place value. No?
Dan Rasmussen: Yeah. These London listed funds are fascinating where you see actual private-equity funds being traded in the public stock market. By the way, if private equity gets put into 401(k)s, it’s going to look a lot like what’s going on in London. It will have to be in a closed-end vehicle that trades either at a premium or discount to NAV. Whether it’s an interval fund where it trades monthly or whether it trades on daily pricing, you’re moving from the quarterly NAVs and complete illiquidity to a world where you have to provide the 401(k)s the ability to trade either on a monthly or daily basis. It’s going to be looking like a closed-end fund, like these London listed vehicles.
They are a really interesting analog to think about what happens if retail gets large access or these access vehicles get created and how they’re going to trade. What you see in London is that these vehicles trade today at about a 30 percent discount to their NAV value. That’s really quite interesting because the secondary market trades at maybe a 10 percent discount to net asset value. The secondary market is obviously a college endowment selling a portfolio as a one-time thing to a secondary firm.
But these London listed vehicles are daily traded, and they’re always quoted. It’s really interesting they trade at a 30 percent discount, and secondaries trade at 10, because what it’s saying is that public markets have lost a lot of confidence that these NAVs are particularly accurate, or perhaps the duration at which they think those NAVs are going to be realized in actual cash flows has been extended.
What’s interesting about these London listed funds is that they’re much more volatile than the public equities generally, which makes sense because the underlying companies are really small and levered and opaque, and they have bigger drawdowns. They trade at a big discount to the NAV.
None of this, I think, bodes well for the inclusion of private assets in retail portfolios. I think if these London listed vehicles are any indication, these private-equity things are going to be treated like other closed-end funds, which is, as someone once described them, they’re sold, not bought, you get sold them, and then the minute after you’re sold them, they trade at a big discount because there’s no natural buyer out there for the assets on the market once you’ve been sold them. I think that’s likely what happens with these private-equity closed-end funds or interval funds that are going to get stuffed into 401(k)s.
Bethany: Let’s go to that question of how private equity gets into 401(k)s. Does it have to be through some kind of closed-end fund vehicle? Is that what all these firms are going to set up?
Then, as a corollary question, the cynic in me thinks when they come for our money, it’s not because they’re helping us. It’s because they need our money because the institutional market is close to tapped out, and so they need another source of growth.
Do you think that’s fair? How much of this push into the retail market, especially on the part of big PE firms, is because they’re doing us an enormous favor and helping us all get rich and save for our retirement? And how much is because they’re at this place in the previous business model where they need fresh money?
Dan Rasmussen: Yeah. Well, as Luigi described it, the college endowments or the original buyers are stuffed to the gills with this stuff already. They want less of it, not more. Private equity has been bailed out by interest from the Middle East. If you went through some of these large private-equity firms and asked what percent of their investors are from the Middle East, it’s a shockingly high percentage. That customer group has replaced the college endowments.
How long will it be until all the sheikhs are stuffed to the gills with private equity and don’t want anymore? I don’t know, but we’re probably pretty close to that. Then they need a new market for growth, and that’s largely retail.
By the way, insurance was another one. Buying insurance firms or getting insurance assets invested in private equity or private credit, that was a big growth area as well. Now that’s tapped out. The next avenue is retail.
Now, they’ve been going to retail through things like iCapital for years. I tend to think that for all of the “sophisticated, high-end, multifamily offices” and those sorts of things, anyone who wanted private equity could get private equity. It’s not been hard to access as a retail investor. If you had a certain amount of assets somewhere with a certain tier of financial advisors, you could get it if you wanted it. Whether you wanted it, who knows? But it’s been accessible.
I think what they’re now trying to do is essentially create vehicles that are even more accessible, which means the closed-end structure where it’s going to be able to be traded on a daily or monthly basis and stuffed into the 401(k) plans.
That’s a rather worrisome development. We have to think about fees. Fees matter. Alphas are scarce; fees are certain. How much alpha is there, and with 2-and-20-type fee structures, is that surmountable in the private markets, and how are they going to surmount it?
By the way, it’s not just going to be a 2-and-20 because there are going to have to be some sort of feeder-fund fees, and you have to remember, there are portfolio-monitoring fees, and all these other underlying fees. Private equity is an enormously high-fee strategy.
Retail investors, thanks to John Bogle and Vanguard, have been well-conditioned to understand the importance of low cost and to feel like they’re being robbed every time their financial advisor proposes something very high fee.
I do think that retail investors, writ large, are going to be fairly skeptical of private equity in their 401(k)s. The pitch that we have unique access to this private-equity vehicle has been a selling point to a certain set of wealthy people, but I’m just not sure it has mass-market appeal.
The optics of private equity for the average American are probably negative. For the average investor who likes index funds, I just don’t know how you’re going to go from owning index funds to putting 20 or 30 percent of your money in a 4 or 5 percent, 6 percent, 7 percent fee-load vehicle.
Luigi: Bethany and I compete on who is most cynical, and in this case, I think I’m more cynical than her because my big fear is not that George Mark—first of all, George Mark might not even have a 401(k)—but George Mark with a 401(k) will wake up in the morning and say, “I want to invest in private equity.” Unfortunately, he might say, “I want to invest in cryptos,” but that’s a different story.
How do these people get to put private equity into their portfolios? There are a lot of various indexes like target retirement funds, opaque things that are marketed heavily by the various providers of the 401(k)s. If the providers are paid enough, they’re going to stuff in this stuff without us knowing.
Whether you believed in the past that private equity was good or bad is irrelevant at this point. It’s facing, in my view, a crisis in this moment precisely because the expansion phase is finished. You’re right, it’s not just the attacks of Trump on universities, but they went from zero to 40 percent. They can’t go above 40 percent even without Trump.
The expansion phase is finished, and when you run out of sheikhs to dump this stuff on, who are the leftovers? Us. I think that this is the biggest bailout of Wall Street by American taxpayers, certainly since the one in 2008, but probably even more historically.
Dan Rasmussen: Yeah. I think that’s exactly right, and I think it’s a very worrisome development, but I think that there are enough skeptical voices. I like to think the American people have more diversity of opinion than your average university endowment staff. I’m hopeful, actually, that this push into retail will not go as well as private-equity titans are expecting.
I do think you’re right that they’re going to try to stuff it into the target-date funds, and they’ll say the 2050 target-date fund is going to have a 20 percent allocation to PE, and that’ll scale back over time.
But to the extent that those funds do start trading in any sort of liquid way, the discounts are going to shock people because they’re going to say, “Wait a second, why is that thing that I invested in at 100 cents in the dollar now trading at 80 cents in the dollar?” That’s going to weigh on performance.
Already, you’re seeing that for endowments and foundations, the smaller endowments, which did not do as much private equity for a whole variety of reasons, are outperforming the larger endowments and have been for the last three to five years. They’re doing so because they have less private equity.
Private equity is now a meaningful drag, just like hedge funds used to be, on large endowments. Selling people on an asset class that actually has bad trailing performance numbers or worse trailing performance numbers than the low-fee index funds, I don’t think that’s that compelling.
Bethany: Can you guys explain to me? I actually don’t understand the concept of being able to stuff this stuff into target-date funds. Can someone explain that to me so that both I and all of our listeners know what to look out for?
Dan Rasmussen: There are these target-date funds, and essentially what they do is they say: “You’re going to retire in 2065. You put your money in this fund, and then we will manage all the underlying investments. The asset allocation will change over time as you get older. There will be a lot of equities early on, and there will be a lot of bonds closer to 2065, and we’re going to change it and adapt it. All you’re going to see as a line item in your portfolio is BlackRock 2065 retirement plan.”
I think that’s where you could stuff a private-equity fund in and nobody would notice because they don’t see private equity as a line item in their portfolio. They just see a target-date fund in their portfolio, and they don’t know what the underlying composition is.
Bethany: Who runs the big target-date funds?
Dan Rasmussen: All the big asset managers have big target-fund businesses. It’s a very common way of providing retirement accounts or retirement vehicles.
Bethany: Do the big Wall Street firms have big target-date funds?
Dan Rasmussen: Of course, Vanguard, BlackRock, everybody.
Bethany: Goldman and Morgan Stanley and Merrill Lynch as well?
Dan Rasmussen: I imagine so. I don’t know every single one, but—
Bethany: I think that’s part of my fear of the corruption here. When you mentioned the financial crisis, I started to think, it actually is really interesting . . . Let me just lay something out and see how you guys both react to this.
Private equity has, for years now, been the biggest fee payer on Wall Street by far. And so, all the Wall Street firms are incentivized to keep the private-equity machine running any way they can because it’s become a huge portion of their investment-banking fees. You can already see it in the unwillingness of any Wall Street firms to ever criticize private equity or to issue sell reports on the publicly traded private-equity firms.
You can see that the Wall Street firms then will also be incentivized to try to keep this going in any way they can. If they’re the ones running the target-date funds, then I can see that being an issue. I can also see the collapse or any problems in the private-equity industry becoming a larger problem for Wall Street in an interesting way because of how tight the linkages are now.
Dan Rasmussen: That’s interesting.
Bethany: What do you guys think of that? Is this me being a complete doomsayer?
Dan Rasmussen: I think there’s a Chinese wall between the asset management and the banks, but the CEOs probably think that way. Generally, people know what’s good for Wall Street, and private equity is very good for Wall Street. The more private equity, the better.
You think of this as a constant war. Everyone wants to make money off your retirement savings. And Jack Bogle, gosh, that guy just eliminated such a huge profit pool. I mean, he just annihilated the active world. And so, everyone’s saying, “Well, how can we get some of those fees back?”
Why not private equity? You don’t need much private equity at 4 or 5 percent, 6 percent per year fees to get your entire thing back up to what the active-management total fee load was 20 years ago. You can totally recover, if not more so, all the losses from indexing that have been inflicted in large asset managers if you can roll out private equity. It’s such a fee generator.
Luigi: Dan, every time I hear the words “Chinese wall” I get an allergic reaction because the Great Wall of China did not work. Why did it not work in protecting against the invasions? The Chinese generals from inside opened the door.
I think that there is a Freudian lapse that everybody uses when they say there’s a Chinese wall, because you have this big construction that looks impenetrable, but eventually, somebody always gets in.
In this respect, I’m much more cynical than Bethany. But I am in a good mood today, and I want to actually be positive. The positive is the following: You run a newsletter that pays attention to this issue. I’m going to call upon you to, number one, call out all the sponsors that stuff this in the target funds. Now I’m creating readers for your newsletter because all the 401(k) holders will read your newsletter to know if your stuff is in it. Second, be a sponsor of a fantastic class-action suit.
Dan Rasmussen: I think there will be.
Luigi: There will be a class-action suit. The only way to protect our 401(k)s is to have a bunch of lawyers ready to jump on any 401(k) administrator who lets this touch a target fund.
Dan Rasmussen: Yep. I like it.
Bethany: Everybody, you are on warning, somebody is paying attention.
Anyway, Dan, thank you so much. It’s always a total delight to talk to you.
Dan Rasmussen: Yeah, my pleasure. Thanks for having me on.
Bethany: Thank you.
Dan Rasmussen: This was a lot of fun.
Luigi: I think that there are a couple of facts that it seems we all agree on, and one is that things have slowed down. They may have slowed down because of Trump, they may have slowed down because of the FTC, they may have slowed down because many universities had reached their maximum that they can push, but they have slowed down.
Many financial assets have an implicit Ponzi element to them. It doesn’t mean that they are necessarily a scam, but it means that the more money is flowing in, the higher returns are, the easier it is to cash out, the more liquidity there is, the easier it is to raise more money—of course, up to a limit, and then once you reach some limit, things start to go in reverse.
It seems that we are approaching this point at the time in which, of course, the fundamental economics of private equity are challenged because it’s easier to do this when there are only a few funds doing it or only a few funds with a certain amount of financial capital to do it. But now, there are a lot of funds doing it. There are a lot of financial capitals, and as Dan said, they’re competing a lot in the entities.
Again, I’ve stopped teaching this for many years now, but when I used to teach it, I remember that one of the key elements is the magic phrase, “We have proprietary deal flows.” What proprietary deal flows means is that I get to know stuff that nobody else knows, and so I can make money out of it. That seems pretty basic.
Now, it’s easier to say the magic words than to have that flow. But that suggests that that was an important element of the industry. If everything is up for an auction, then it’s very difficult to make money. But also, at the end of the day, the industry of private equity is about choosing talented managers. The fear that this choice is going to be delegated to the 401(k) holders at the worst moment in the history of private equity is not really very inspiring.
Bethany: Yeah, it’s not inspiring at all. And private equity’s intense lobbying to get their hands on 401(k) money may turn out to be a real black mark against the industry in the future. One thing that struck me in preparing for this episode is that very few people have anything positive to say about it. Most longtime financial commentators, especially, are saying, “Whoa, what are you doing?” Everyone understands that it’s a naked grab for fees.
We didn’t touch on the fact that many of the big private-equity firms are now publicly traded, which always was a huge irony because their pitch was that it’s so much better to be private because you don’t have to have quarterly earnings pressure. Then they took themselves public so they could get their money out.
As part of going public, the main metric that investors score the publicly traded companies on is growth and assets under management because the fees from steady growth and assets under management are more reliable than the fees you get from having a fund that really, really performs well. So they’re doing almost anything they can to grow their assets under management, which also means getting their hands on your money. I worry that it is an ugly thing to do in a way that is destabilizing.
I was thinking of a few other things that have made me worried about private equity or worried about the future of it. I shouldn’t say I’m worried because I’m not. Whatever happens, happens.
But I thought private equity’s push into healthcare in recent years is also perhaps a sign that the asset class is reaching its peak. Back to that idea that there are things you won’t do when you don’t have to do them, I think private equity kept its hands off healthcare for the most part because it’s a messy business. It’s a messy business because there are times where you have to make bottom-line trade-offs in order to do the right things by your customers, where people’s lives are at stake. That makes it a business where if Milton Friedman’s prescription were ever true, it’s really not true in healthcare. At least it’s difficult to make it true all the time. I thought private equity’s increased willingness to do ugly things in the healthcare world is a sign that there isn’t that much left for them to invest in.
Luigi: Yeah. I think we should have a separate episode on the benefits or the disaster of private equity, but I want to go more into the political economy because I was thinking about why Trump is doing this. Clearly this is what Stephen Schwarzman and some of his billionaire friends are happy with, but at some level, you say, “This is really damaging the American people.”
Then I had this moment when I said, “Wait a second, not everybody has a 401(k).” As it turns out, 401(k)s are mostly in a certain level of the private sector, but if you are in the public sector, especially lower-level jobs, more traditional jobs, et cetera, either you don’t have a pension or you have a defined-benefit pension. Think about the firefighters and the policemen and et cetera.
This is really the ultimate politics of Trump: an alliance between the billionaires and the lower half of the income distribution against the so-called elite that represent from 51 to 99.9 percent. Then the 0.1 percent are the billionaires, and these are really the people that are going to be affected. The firefighters are not going to be affected. The billionaires are gaining at the expense of whom? The people of the 401(k)s, who are mostly Democrats.
Bethany: I actually thought maybe you were going somewhere else with that. I had not thought of this until you started down this line of thinking, when you had mentioned that this was a bailout of Wall Street, but this could actually also be a bailout of pension plans because pension plans are heavily invested in private equity. All those people who don’t have 401(k)s and aren’t invested in the stock market are exposed to private equity through their defined-benefit plans.
If you get instead all the people with 401(k)s to put their money into this industry and bail out these investments that have been made by pension funds with this whole fresh new wave of money, not only do you benefit the billionaire class, but you also might bail out the pension funds that otherwise are going to be choking on all of these private-equity investments that they’ve made, with now no exit plan for them and no distributions coming out of them because the upper middle class becomes the distribution and becomes the bailout.
Luigi: We’re saying the same thing.
Bethany: I know. You just didn’t quite take it to the next level of cynicism, which is that it’s not just an alliance, but it actually is a bailout. I had not thought of that. You know what? You are more cynical than I am, Luigi.
Luigi: It occurred to me that this explains a lot of Trump’s policies because it’s a little bit like in the ancien regime, the kings had a lot of support among the lower class. The French Revolution was a revolution of the bourgeoisie against the king, and it’s not obvious that the lowest, lowest class was better off after the revolution. In fact, you might argue the other way around.
Our “friend” Curtis Yarvin wants to reintroduce absolute monarchy. I think that that’s exactly what it is. It’s like the billionaires with the support of the lowest class at the expense of the middle.
Bethany: Yeah. And it’s also a bailout of Wall Street. It’s a bailout of Wall Street, it’s a bailout of pension funds, and it’s more money to the billionaire class. And it’s at the expense of everyone whose 401(k) might be put into private equity that is now going to have to swallow all these losses.
Oh, God. Let’s say something encouraging and happy about the world. It’s the end of summer.
Luigi: I actually think that my proposal, if I may say, was a good one to create some sentinel that will trigger the attention of lawyers to go after everybody who does that.
Bethany: Any lawyers listening? Well, yes, and I think it might be the case that people are too smart for this. It really has been encouraging because, like I said, I don’t think I’ve seen anyone write positively about this development. People have said, “What is this?” Especially with the fees, the illiquidity, the problems in the industry. So there’s a chance that it doesn’t work, because if people do have a chance to say no, and it’s not just stuffed into these target-date funds, they will say no.
Luigi: Yeah. But the vast majority of people don’t reallocate their money in their 401(k). The default option is everything, and the default option is influenced dramatically by the 401(k) administrator. The 401(k) administrator can do a lot of things.
That’s the reason why the only way to prevent this is the threat of gigantic legal suits. Unfortunately, what I fear is that a lot of the people who are going to play this game are people who grab the money and run, and then the legal suit is going to hit the firm 20 years later or 10 years later. Who is going to pay for the cost of the litigation? The shareholders, which is us through our 401(k)s.
Bethany: Maybe instead of this being a call to class-action lawyers, maybe this is just a call for people who work at companies with a 401(k) as this rule change goes into effect to lobby your company and say, “We do not want private-equity investments in our 401(k), and we, as the workers of this company and the employees who are invested in this 401(k), we don’t want it.” Maybe that’s something that employees of companies can rally around to just say no.
Luigi: Now your new rallying cry is, “Workers of the world, unite against private equity.”
Bethany: Geez, it’s going to make me even more friends, Luigi. That’s my goal in life.