Episode #361: Jeff Hooke, Johns Hopkins, “The Buyout Business…Has Not Outperformed The Public Stock Markets For The Last 10 or 15 Years”
Guest: Jeff Hooke is a broad-based finance and investment executive with global experience throughout the U.S., Europe and the emerging markets of Latin America and Asia. He was a Managing Director of Focus Securities, an M&A-oriented boutique investment bank, prior to joining Carey. Earlier, Hooke focused on emerging market investment and private equity. He was a director at the Emerging Markets Partnership, a $5 billion private equity group. Earlier, he was a Principal Investment Officer of the International Finance Corporation, the $30 billion private sector division of the World Bank.
Date Recorded: 10/6/2021 | Run-Time: 54:12
Summary: In today’s episode, Jeff pulls no punches when sharing his thoughts on the private equity industry. He likens the belief that private equity has outperformed the market to believing the tooth fairy is real and compares their reporting process to an 8-year-old girl rating her own homework. We dive deeper into the lack of transparency around fees and returns and then discuss the recent approval to allow 401(k) plans to include private equity investments and why that goes against what the great John Bogle believed.
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Links from the Episode:
- 1:52 – Intro
- 2:36 – Welcome to our guest, Jeff Hooke; The Myth of Private Equity
- 4:50 – An overview of the different types of private equity
- 6:52 – The inspiration that lead him to writing The Myth of Private Equity
- 8:20 – General thesis and appeal historically for investing in private equity
- 11:17 – Whether or not the top quartile defense is a valid rebuttal
- 14:01 – The struggles and challenges of showing how these types of funds perform
- 18:13 – Why a private equity structure continues to exist in a world of nearly 0% ETFs
- 21:35 – Should A Robot Be Managing CalPERS Portfolio?; Turning the dial on leverage to match mid-cap value
- 23:22 – Implementing change often means admitting you’re wrong
- 24:35 – Episode #90: Dan Rasmussen, Verdad; Paywall reporting and perverse incentives
- 27:13 – How carried interest has escaped the tax reform discussion
- 29:45 – Everlasting myths and coming changes that may impact the private equity space
- 33:07 – Are giant capacity private equity funds even possible?
- 36:49 – Pioneering: Portfolio Management
- 38:31 – How much fee incentives can be better aligned to serve clients with regulation and legislation
- 41:39 – A lack of financial literacy among high schools and politicians
- 44:28 – Overview of the poor returns of the Pennsylvania pension fund
- 46:12 – The most memorable investment or deal that Jeff worked on in his career
- 50:12 – Learn more about Jeff; jeffhooke.com, LinkedIn
Transcript of Episode 361:
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Disclaimer: Meb Faber is the co-founder and chief investment officer at Cambria Investment Management. Due to industry regulations, he will not discuss any of Cambria’s funds on this podcast. All opinions expressed by podcast participants are solely their own opinions and do not reflect the opinion of Cambria Investment Management or its affiliates. For more information, visit cambriainvestments.com.
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Meb: Hello, friends. Today, we got a great show. Our guest is a senior lecturer at the John Hopkins Carey Business School and author of the new book “The Myth of Private Equity.” In today’s show, our guest pulls no punches when sharing his thoughts on the PE industry. He likens the belief that private equity has outperformed the market to believing the tooth fairy is real and compares their reporting process to an eight-year-old rating their own homework. Ouch. We dive deeper into the lack of transparency around fees and returns and then discuss the recent approval to allow 401k plans to include private equity investments and why that goes against what the great John Bogle believed in. Please enjoy this episode with John Hopkins, Jeff Hooke. Jeff, welcome to the show.
Jeff: I’m glad I could come.
Meb: Well, look, I’m excited to talk to you today. I just cranked on your new book, “The Myth of Private Equity.” And our listeners are probably going to be familiar with this topic. But I want to go back because I grew up partially in Colorado and partially in North Carolina. And in North Carolina, the town that I went to high school in was Winston-Salem, North Carolina. And the high school was R. J. Reynolds High School, which I thought would set the stage because this is arguably, at the time… I mean, it’s still probably the most famous. I don’t think it’s the biggest anymore. It might be leveraged buyout in history. Is that right? Is it still the biggest. It can’t certainly be the biggest, can it?
Jeff: There was a bigger one done about 10 years ago called TXU Energy Futures, which, by the way, as an anecdote for the listeners.
The biggest leveraged buyout ever went bust, bankrupt. Equity investors were wiped out.
But when you talk about the RJR-Nabisco deal, and, of course, it was heavy tobacco, but also a big food company, that one didn’t do so hot either. I mean, returns for that were kind of mediocre. But that one really set the stage. In fact, Hollywood made a movie about that particular deal, which you don’t see too often.
Meb: A great book too “Barbarians at the Gate,” what many would consider outside of the business world to be sort of a button-down universe. There can be a lot of intrigue and personalities involved as well. It’s really a great book.
Jeff: Well, when I was at Lehman Brothers in the ’90s, of course, Lehman was one of the investment banks working with people that were bidding on that $25 billion deal. And I’ll never forget walking into the elevator as a young investment banker and there were all the Titans that were working on that huge transaction going down the elevator with me. There weren’t too many smiles in the elevator, lots of frowns, Lehman never did get that deal. It went to another firm.
Meb: Yeah, it’s funny. I had a grandfather that was at Reynolds back in the day and so it brings back some fond memories. There are some other good books on that world of M&A. There was a great one about the Marvel comic book universe but before we get too deep and start on the topic of the book, why don’t you give the listeners…? I feel like in the media, they say private equity and sometimes the people saying it are referring specifically to leveraged buyouts. Sometimes, they’re talking about the entire industry, including venture capital and growth. And who knows what else we have now. Give us a quick overview so we can kind of lay out the jargon and start to dig in here.
Jeff: Well, there are three kinds of private equity, as you pointed out. There are leveraged buyouts, there’s venture capital, and there’s growth equity. The book’s about leveraged buyouts, which are about two-thirds of the industry. So a leveraged buyout in simple terms is a group of investors collectively put money into a fund. And then, the fund runs out, looks for companies that are sort of low tech, profitable, very consistent, and then, leverages it up much like people might leverage up a real estate investment far above what is the normal practice. So instead of say, a company having 20% debt, it’ll have maybe 70% or 80%. So that’s the main business. The other parts, venture capital, everybody thinks venture capital is a guy starting a company in a garage, and then the venture capitalists come in and help fund them. I mean, that’s part of venture capital. They tend to be more established companies in which venture operates and then they’re too young. They’re too young to go public. So this is an interesting bridge.
Growth capital is sort of a little more mature venture capital fund where they’re targeting companies that are a little older than the venture guys, and maybe would not have a lot of the high-tech flavor that you see in VC. The whole venture and private equity or LBO sector has been endlessly hyped in the media. And so the book it’s sort of a exposé of the largest part, an exposé of the leveraged buyout business, which is always trumpeted as being full of geniuses, and I try to dispel some of these notions.
Meb: Well, good. We’re going to dig in, and you’ve certainly written a lot of books and have a distinguished career. What was the sort of the inspiration for this book? Was it just something that was kind of gnawing at you and you said, “Man, I got to birth this thing. I can’t hold it in any longer.” What was the origin story for the book?
Jeff: You’re exactly what happened. Even though I was a private equity investor, off and on for several years at various jobs, and I was an investment banker, and I always knew how the business operated, of course, I was always skeptical of returns. I had done a little work at Johns Hopkins. But as a practitioner, I was skeptical. However, I’ve written books. I know how much work it is. So I was always hesitant to dive into this swimming pool and actually write another one. But I saw another endlessly-hyped article about the business in “The Washington Post,” and I said, “Look, we got to draw the line somewhere.” So I stuck my hand up and volunteered to do it. It’s a lot of work. I don’t recommend writing books for your listeners. But I did do it. I thought I was in a unique position to write such a book, having done academic work, examining the private equity business, and, of course, being a practitioner who had done a lot of deals.
Meb: I agree with you. And so some of today is going to be me trying to play devil’s advocate and ask questions from, like, almost a journalistic standpoint. We were writing about sort of similar topics to dis on the hedge fund industry many years ago, as well. But let’s start in the beginning. So private equity, the thesis for the private equity management companies, as well as the investors, historically, is you invest in it because it outperforms the S&P. So I figured we’ll start there. Maybe walk us through sort of like, the myth, the allure, and also just kind of what actually happens in an LBO? Like, what’s the actual process that is involved?
Jeff: All right, so let’s start off a private equity LBO fund, it’s run by 5 or 10 people like me, investment bankers. We don’t know how to operate a company. But we do know how to find M&A deals and close. So we’re running around looking for companies to buy. And the idea is the fund will, let’s say, buy a company for $150 million. Now, the basic principle in finance, as I’m sure some of your listeners know, is the more debt or leverage you put on a company, supposedly, if things work out, the higher will be your return on your investment. So you enhance the returns by using leverage. That’s the whole principle behind the business. It’s nothing simple.
And it’s just like if you bought a house for $200,000, if you borrow $150,000 of the $200,000 purchase price, and the house increases in value, say $25,000 the next year, well, you’ve done pretty well. You’ve only put $50,000 down in your equity and the house has gone up by $25,000. That’s a 50% return because you borrowed most of the money. Of course, it works both ways. If you borrow a lot of money on a house, you borrow $150,000, the house drops in value by $25,000, half of your investment has been wiped out.
So the basic principle… And it did work through a few years, I mean, the basic principle of putting on more leverage on companies, which I guess most family business is and a lot of public companies are a little conservative. By putting in more debt, you could increase the equity returns that lasted about a dozen years. And then, much to the chagrin of the investors, I suppose, or they refuse to acknowledge it, but say after the early 2000s, everybody started piling in and doing the same thing. You had a limited number of buyout targets. The price shot up. And as prices go up on an asset or an investment, the return inevitably drops. So that’s been the case for the last 15 years. It’s sort of been a well-hidden secret.
But the buyout business, much to the surprise of some people, has not outperformed the public stock markets for the last 10 or 15 years.
That may shock some of your listeners because what you see in social media or the financial press often seems to indicate the exact opposite.
Meb: I feel like the argument usually goes like this. If you can get a firm to admit that, hey, private equity, in general, has underperformed, just a broad base equity investment. And I feel like the response almost always is, “Yeah, but there’s persistence here. And so you have to invest in the top quartile.” If you’re not in the top quartile, yeah, obviously, it’s just going to be like the S&P or worse, but clearly, we’re going to be top quartile. Does that argument hold any water? Because I hear it all the time.
Jeff: So do I, and it’s sort of like an urban myth, sort of like the tooth fairy. So if you have a belief in the tooth fairy, you’re going to believe the argument you just stated. The fact of the matter is that, as you suggest, most of the premium returns of the buyout business are in the top quartile. That means out of 100 funds, only the top 25 actually beat the public markets. So that doesn’t say much for the other 75 funds. So that should throw a lot of caution into anyone listening who’s thinking of investing in this if 75% of them can’t even beat a public market. And despite them having so much analysis and expertise, they can’t do it. So the top 25%, that’s the goal to try to climb into that category with your own money. There’s a bit of an issue there, which tends to expose itself upon further study. And that’s if you do that, you tend to as an investor, you’re saying, “Well, fund number three of this particular manager, fund number three, was in the top quartile.” They got lucky, so to speak. And now I’m thinking about investing in fund number four. So you say, “Well, fund number three did pretty well. So should fund number four,” a little bit like if a baseball player batted 300 last year, you think they might bat 300 this year. But there is no persistence in private equity, which is kind of surprising, not only to me but to other people I’ve talked to.
So if fund number three was in the first quartile, the top division, so to speak, the chances of the next fund that going into the top quartile is 25%.
It’s completely random. So the chances of an X fund going into the second, third, or fourth quartile is equally the same as it repeating its performance. So the persistence or the ability to repeat performance is simply not there.
Meb: One of my favorite stats you had was talking about how, and this was a big issue with the hedge fund databases too, back in the day, is it’s the self-reporting. And there’s like a half a dozen different databases and across any one, it’s like I forget the exact number and you can correct me, but it’s like half the funds aren’t in there or something. And so you get into all these issues about reporting and survivorship bias and self-selection. When we used to look back at the hedge fund indices, there was about a 4% gap between the published indices and the investable ones. And the investable ones were clearly the ones that you could actually put money into and were still around and that’s a pretty massive difference. But all of the… Even like calculating the performance, there’s a bunch of shenanigans as well. Maybe talk about all those struggles and challenges of even coming up with, like, how did these funds even perform.
Jeff: Well, before I start, I just thought I’d throw one aside about hedge funds because I was once a consultant for the New Jersey State Unions who were a little worried about all the fees being paid out to hedge funds and private equity funds, and not getting good investment results, even though they’re paying hundreds of millions of fees. I did look at about a portfolio of 100 hedge funds. And despite all their fantastical claims, collectively, they didn’t beat a 60/40 index, which is 60% stocks and 40% bonds. They didn’t beat it. They were under it. That was a little shocking to me. But anyway, let’s get back to private equity for a second. So you make a good point. Most of the investments your listeners should know in leveraged buyout funds for the last 10 years, most of the deals have not been sold. So these terrific investments that are sitting in these funds, no one seems to want to buy them because if someone wanted to buy them, they would have been sold already. Why would you hang on to something for 10 years?
So while these investments are not being sold, while they’re sitting there inside the fund, the fund still has to report what its rate of return is every year. Just like you would if you were running a public mutual fund every three months or a year, you have to tell how you did in terms of your results. Well, so for them since so many of the deals are unsold, they have to estimate or I call it guesstimate what the underlying unsold companies are really worth. And there, you get into some shenanigans, as you suggested. The temptation, which I think many funds have a hard time resisting, is to smooth out the results of the fund so they’re not as volatile as a public stock portfolio, and then maybe to inflate the values in the early years to make themselves look good. Funds have a 10-year life. So if the investments aren’t sold for eight or nine years, people are going to kind of forget what were the reported or are the so-called claimed results in the early year. And the whole system, it just isn’t designed logically. It’s sort of like an eight-year-old girl grading her own homework. She’s always going to give herself a good grade. There aren’t many checks and balances.
Meb: The odd part to me is that the careers and the incentives of the LPs that are making these allocations, usually 10 years, like if they make a bad decision, 10 years, what’s the chances they’re even going to still be at the organization? Pretty slim. And so what happens to these orphan companies? If a PE firm buys a company and they can’t sell it, does it eventually…? What do the LPs do? They’re just stuck, stranded?
Jeff: Well, look, there’s going to be a buyer for almost anything at a price. So it’s not like they’ve got to sit there and hold it forever. I mean, after 10 or 12 years, if it’s still on the shelf, they just got to do a bargain sale. They got to have a 30% off. And that’s what’s going to happen for a lot of these companies, which in the business are sort of called Zombies. They’re the walking dead. They’re waiting to get sold.
Meb: Here’s the mystery to me. You can help enlighten the struggle. So there’s an enormous amount of academic literature. You summarize a lot of it in your book. We’ll add the links to the show notes, listeners, on private equity performance, the challenges. And yet it still exists, and it continues to not only still exist, it continues to get bigger and bigger. And the fees are traditionally… They may be negotiated down. But I think 2% and maybe a 20 over a hurdle. In a world of 0% essentially ETFs, why do you think this structure continues? They’re just waiting for your book to come out, but like, why is there I don’t know $500 billion?
Jeff: Well, let’s start off with the academic literature first. When you talk to people in the business, they’ll say, “Well, nobody reads academic literature. It’s written in a very obtuse way. It’s got full of numbers, and it’s mind-numbing to flip through it.” So most people in the business are not going to read academic literature. Some people in the practitioner community have come out with studies sort of echoing what I’ve said, and I’ve referenced them, somebody like McKinsey and Bain. And so more people would read that. And they’re getting a little more exposure, in terms of telling people, “Okay, the results aren’t what they’ve claimed.” This business is not the end-all that people have pushed it to be for the last 10 or 15 years. So you have a situation where the word is slowly getting out. Now, what’s the story with the people managing tens of billions of dollars at these state pension funds, and university endowments, and these non-profit foundations? And I get that question a lot. All right, Jeff. If the returns are mediocre, why do they do it? Well, you got to put yourself in the shoes of running a university endowment. For example, you’re getting paid $2 million a year. You’re getting paid probably more than the president of the university.
So it’s in your interest to make the job look totally complicated, and complex. You throw around all kinds of mathematical terms like beta, and R-squared, and so on. So the job looks so complex, you tell them, “I just can’t buy public stocks and equities. I got to buy hedge funds. I got to buy private equity. I have to buy commodities.” A couple people in your show, for example, say, “We got to buy farmland.” So it’s very complicated. And as a result, I have to get paid $2 million here. Upon further inspection, the people on the board of trustees of said university should figure out that 90% of universities or state pension funds or foundation, 90% plus, do not beat a simple 60/40 index. Therefore, you don’t need an investment staff with all these complicated exotic investments like leveraged buyout funds. You ought to just buy public stocks and bonds and index them and save yourself tens, hundreds of millions in fees, but that doesn’t help the manager keep his or her $2 million salary. So you have a sort of a governance problem, I suppose you might call it, in corporate words, a court governance problem or a fiduciary problem, say in the investment business. And it’s a sad thing to behold.
Meb: We’ve written a handful of articles over the years. I told you this is tough because I agree with you, but talking about a lot of the big institutions and the headline being something like, “Should CalPERS be managed by a robot,” and demonstrating what a broad, simple asset allocation would have looked like for the past few decades. And even, we’ve had a lot of people on this show, going back to even the beginning, that have written some academic papers on the topic of replicating a lot of these strategies with publicly traded vehicles. And simply, just you can kind of turn the dial on the leverage to match them. And most of the research that you outline in the book shows that, hey, private equity, you can match with a pretty simple mid-cap value, or even S&P with just a little more leverage. Just turn the dial and there you go.
Jeff: Exactly. And, of course, if you wanted to get a little more say specific, you would screen say the Russell 3000 for low-tech companies that steadily make money. So that screen if you were to do it would probably cut the Russell 3000 to say the Russell 600. Then, you would simply by that pool of 600 stocks. If you wanted to add a little leverage to mirror the LBO leverage, as you indicate, it would be a simple thing to do. You just borrow and margin, except the issue with that… And I actually had a formula that did that I did it with a professor a few years ago. When I approached some institutional consultants, he said, “Forget it. The institutions won’t buy it. And neither will the money managers. No one is going to pay someone $2 million a year to invest in a replicating index.” That’s why you don’t see them around. There’s no money in it for either the investment consultants or the managers running these big pools of cash.
Meb: I had a humorous, depending on your perspective, and let’s see. It may not be that humorous to some of the listeners. But I jokingly…not even jokingly, I seriously applied for the open CalPERS CIO position. Then, I said, “However, what I plan to do over the course of the next decade,” saw this on Twitter, I said, I’ll work for free. I’ll put you in a basket of ETFs. We’ll slowly sell off all of these private investments and probably save you hundreds of millions of dollars, billions of dollars over the ensuing years on fees and salary.” And they haven’t responded to my application yet. It’s on the Cal website. So CalPERS, if you guys are listening, at least deny me. Give me an interview.
Jeff: I did exactly the same thing, I think, for the Georgia State Pension Fund. But I knew the headhunter would never get back to me. The people running the show, if they were to accept your job application, that would be to admit, “Hey, I did something wrong last five years when I was sitting on the board. I screwed up. We should have indexed and saved billions of dollars in fees.” Most people in the business are not going to want to admit they did something wrong.
Meb: And so how do you think this resolves? I mean, one of the things… We had Rasmussen on the show in years past. And one of the things he was talking about was looking at either the vintage years or the actual investments. And the ones that were really cheap, whether I think it was enterprise value to EBITDA, just on a quantitative measure did better. And so looking back at the history of sort of private equity, maybe 20, 30 years ago, there was a little bit of a private versus public valuations spread. But not only has that collapsed, it might even be inverted at this point. Do you think it’s just a scenario where after 1, 3, 5 years of, like, terrible performance, you’ll see these funds start to decline, or is it just too intermeshed with incentives of the different players? Like, how does this play out in the 2020s?
Jeff: Well, as you know, as we talked about, they did have a good run in the 1990s and early 2000s. It’s been downhill ever since. But because everything is super-secret, you can’t really look at results on Google, or you have to pay to get results. All these data services tend to be pay-wall. You do see the occasional report by say, a professor by consulting firm, but a lot of the card information is pay-walled. It’s secret, a lot of the information even though let’s say you as a taxpayer… I know you live in California. You think the information should be public. A lot of states have passed laws keeping the results secret as if private equity fees and results are equal to the nuclear launch codes that President Biden has. So it’s all kind of mysterious. There’s been an aura of invincibility that the media has put on these private equity funds.
So to reversing all of that, it’s built up over 15 or 20 years is a little tough for any kind of truth seeker. And then when people say, “Well, how’s it going to be resolved in the 5 or 10 years,” it ain’t. I mean, the momentum is so strong, I can’t see anything reversing the next 5 or 10 years. In fact, despite the information you and I have talked about in the last few minutes, the business is bigger than ever. There have been, I don’t know, 7 or 8, 10 million-dollar-plus funds, new ones, new funds launched in the last year. And it just shows you the institutional investors not really individuals, institutional investors, because of the governance issues we discussed a few minutes ago, are totally behind this business, even if the results are sorely lacking.
Meb: Maybe just like private equity had so much money and such a good lobby. And there are so many periphery beneficiaries, whether it’s the legal, whether it’s the banks, whether it’s the consultants or a big one. How do you think carried interest has escaped the discussion? There’s some proposals going on right now in the government. Hopefully, by the time this goes to press that some of them have been reviewed. How do you think they escaped the regulator’s wanting to tax that sort of loophole? Do you think that’s something that should be closed? And why are they out of the spotlight?
Jeff: Okay, well, I live near the swamp. I live right outside of Washington, DC. My wife, I confess, used to work on Capitol Hill. She used to work for a Congresswoman. So I got a little insight into this, I think. I used to work for a non-profit think tank that used to do a lot of policy work. Then, I went back to investment banking. The lobby is too strong. Even though what you said would be justifiable, the carry interest tax, and it’s very low, is one of the most unfair taxes in the United States. Even someone like Warren Buffett has pointed that out. I mean, you do get the occasional grenade thrower like Elizabeth Warren or AOC saying it’s an unfair tax and it benefits billionaires. But I got news for your listeners. The top 30,000 contributors of two politicians in the United States, the top 30,000, probably gets 70% or 80% of the contributions. So they call a lot of the shots on these inside baseball-type legislative proposals, and I would put carry interest in that category. It’s inside baseball. Most voters don’t know what it is. Maybe they don’t care. If you explained it to them I think they’d care but most of them don’t get it. So it’s one of those Washington-type issues. It keeps getting pushed around.
And there was another working with a non-profit. Now, we’re looking at disclosure, something we just talked about, disclosing the fees. How about telling the taxpayers and the union people who rely on these pension plans, how about telling them how much fees your pension plans playing out to hedge funds and private equity billionaires? Is that so unfair? Those bills, and there’s been a few of them over the last 15 years, have all died in committee. It’s like the wagon train you see on TV and those old shows with the skeletons of the cows in the desert. What happens to those bills?
Meb: How much do you think has changed in the industry? I mean, part of what I’m going to refer to here is some of the LPs are wising up. I remember reading a report by not Rockefeller, who was it? Kauffman Foundation. They were talking specifically about Venture Capital, but the name of it is, “We Have Met the Enemy.” And he is talking about their failed experience in investing in that category. Things are changing a little bit. You’re starting to have this sort of spectrum of weird private-public where companies have been waiting to go public later. So you’re starting to see the public market investors go downstream into private markets. Is that going to end up having any effect on this asset class? In my opinion, is probably this. Anytime you look at traditional sources of alpha, they eventually get commoditized or meaning the 2 and 20 gets knocked down to 30 dips or something. Are there any changes afoot or anything that you think extra that is worth noting, or is notable, that we’ve kind of haven’t covered as far as what the status is today versus maybe 5, 10, 20 years ago?
Jeff: The myth has been perpetuated for the last 15 years. Despite the lousy returns or the mediocre returns, the fees to the private equity managers pretty much remain unchanged. And what’s surprising is not only is there a fixed fee component that lasts for 10 years, 10 years, no cut contract, paid, whether you make money or not. And then there’s the carried interest or the performance, which is an incentive. But it’s not even key to the public market. So if the public markets go up, and you kind of beat the public markets by a small amount, well, you should actually not share in the profits. The market itself has propelled your investments to new value. I mean, one thing we haven’t covered is why should… I mean, clearly, a retail investor may have an intellectual interest in the subject. But there is actually a sort of an indirect effect that particularly for those listeners who are taxpayers, and, well, I guess that would include all of us, but particularly for those that are union employees are retiring or thinking of retiring after working at a state or city government for 20 or 30 years.
The fact that these exotic investment managers of private equity or hedge funds are extracting fees and not providing returns is bad. It’s basically going to hurt your future pension payments. And so that’s not good. So that is something you want to think about. Even in the abstract notion like private equity, you have one indirect, you have one intellectual curiosity, a couple of reasons to think about it. The third, which we haven’t brought up, the government recently gave the green light to the 401k administrators to stuff private equity into portfolios of average people in their retirement portfolios. Before last year, private equity was limited to people with a net worth of $2 million or more. So now, this under-performing, opaque, high-fee investment alternative is going to be directed at widows and orphans. I don’t think it’s right.
Meb: Not only that, we’ve seen… I imagine he’d be rolling over in his grave, but John Bogle, Vanguard is rolling out private equity funds under their own banner, which I imagine is a bit of an oddity. There’s been quite a reaction from, I think, the advisor community scratching their heads on this idea, particularly at their scale. I mean, if you’re going to make the argument on private equity, I feel like the only argument you can try to make is you are an amazing company that’s targeting, like, an inefficient portion of the private equity universe and you’re small. But if you’re Vanguard, Vanguard is $8 trillion at this point. I don’t know how you even consider a giant capacity private equity fund is even remotely possible.
Jeff: Now, when I saw that announcement by Vanguard I almost fell out of my chair. What does that tell you? It tells you they drank the Kool-Aid. So they drank the Kool-Aid. They decided to jump in with both feet and just try to make some money. It’s probably not a good thing for their clients. But they just can’t resist the temptation. They’ve got a big client base. They have been selling on these low-cost funds. Now, it’s time to sell them some high-cost funds. So they basically raised the white flag. They said, “We can’t fight it. Maybe our clients have been following the private equity hype, and they want to get into it.” So they don’t want to lose the client. Maybe this is their strategy to try to keep them, just offering something different.
Meb: I wonder how much I think it was accurate and harsh and fair, all in one. I mean, looking at some of the boards and people running a lot of these organizations, David Swensen, arguably one of the greatest allocators ever with his track record, had a very untraditional portfolio. But even looking at his books and looking at the way he describes the world, I think he would have been the first to admit that you have to be looking in places where not everyone is. And the way that the industry has now $500 billion or whatever it is, and sort of private equity sort of commits, it seems like a well-wallpapered over the world. But I wonder how much of the institutional world is really drafting off the coattails of like the Yale’s and Harvard’s from 20 years ago, where they said, “Man, we got to be doing this because they are and we’re under-performing?” Do you think there’s an element to that?
Jeff: Everything you said is true. I mean, David Swensen was a pioneer, along with the state of Washington pension bond in the state of Oregon. They were the first ones… Institutional Yale University, of course, where David Swensen worked, the endowment was quite large to begin with. They were the three big institutions that really got the ball rolling in private equity. So they were in early. The deals were cheaper back then. So they had a very good run. Even David Swensen, who, of course, his performance coined the Yale model of endowments, which were then copied by pension funds where you put a sprinkling, which then grew up to be a big chunk of your portfolio in these exotic instruments, even he was unable to be a passive 60/40 index the last 10 years. And he acknowledged publicly that it’s very tough to duplicate his performance since so many people have crowded into the business. And even if you look at what say, Warren Buffett, I mean, he doesn’t talk much about the competition. But he has critiqued, as has Charlie Munger, his partner private equity, both for its performance and for its opaqueness in results and fees.
Meb: The interesting part about Swensen’s books, I mean, one of them was literally named “Pioneering Portfolio Management.” But he talked a lot about on the retail side, investing a low-cost portfolio of ETFs and funds as a great way to go about it. One of our very first interviews on the podcast was a guy named Peter Medina who wrote a paper on replicating some of the top endowments through publicly-traded vehicles and factor exposures. That’s a pretty great paper. If we can dig it up, we’ll add it to the show note links as well.
Jeff: It’s surprising that you can duplicate so many of these portfolio strategies with passive indexes. Boy, you save a lot of money if you do that, but as you alluded to earlier, if you save a lot of money running an investment fund, then a lot of people are not going to be going to Europe on expensive vacations. They’re not going to be buying a penthouse on Park Avenue in New York, nor are they going to be buying a beach house at Malibu. You’re going to ask everybody to cut costs. So that’s not going to happen. What you got to remember, when you look at this asset class, is they’re taking…they, the managers, are taking 3% or 4%, off the top in management fees, 3% or 4% off the top. If you’re competing with an index fund, let’s say you want to just do the S&P 500 index fund, you’re looking at one-tenth of 1%. So the fees are 30 or 40 times higher. And if you look at it mathematically, it’s almost impossible to pay 3% or 4% in fees and to beat the market. I mean, you’d have to be incredibly lucky.
Meb: Well, and then on top of that, one of my beliefs, which has turned out to be wrong, is, and particularly in a world of lower interest rates, the challenge of fees is a percentage of probably the expected return, or fees as a percentage of the risk fee rate are so much higher now than when bonds were at 5% or 8%. Right? And so it should make people even more fee conscious. Now, the odd part is it’s playing out in the public world. So every year, the gap of the low-cost funds versus the expensive, the flows are moving that way, so good. Someone’s getting it on that side. But in the private institutional world, it still has its foothold. I wondered how much of this would change if there was more like accountability from the board, sort of, side. And it’s tough because performance doesn’t necessarily play out in the short term. I wonder how you get the incentives on the board side aligned or if you can. It’s almost an unsolvable problem. Is there any legislation or any ideas?
Jeff: Well, let’s look at the typical composition of a board of a public pension fund like the state of Maryland where I live or the state of Colorado or the state of California. Who’s on the board. Well, usually, it’s a statutory board. So you have six or seven representatives of the beneficiaries, which would be all the state employee unions. So these people, while they’re smart, they’re head of the Union. They’re not really financially sophisticated. The other statutory appointees are usually a few politicians. None of them are real finance experts. And then you may have one or two political appointees with some knowledge of the business who got on the board because they knew the governor or the state treasurer, maybe they gave some money to the campaign or something like that. So you got a board, which is not really financially sophisticated. So who’s running the show at the board meetings? I’ve been to a couple of them the managers, the employees, the inmates are running the asylum. And they, as we’ve talked about, have a vested interest in keeping things the way they are, very complicated, lots of different investments, high fees, and that turns into high compensation for them and job security. So how do you get the boards to kind of turn around? I just think it’s mission impossible. They don’t have the sophistication.
So I was giving a talk just yesterday at a CFA meeting. They invited me to come on to talk about the book. I’ve been a speaker at other CFAs around the world. This was kind of local, and one of the people sitting there at lunch was a board member of a large pension plan. He didn’t really kind of know the things you and I are covering. He didn’t know that the institution did not beat the 60/40 index. He didn’t know that the [inaudible 00:41:29] fees were 3% or 4% off the top. He didn’t know that PE did not feed a passive publican. He didn’t know any of that. I was a little taken aback.
Meb: Every time I get frustrated with some of the discourse and discussions that are going on with politicians, and particularly in a couple areas, I say this, and it’s partially joking, but partially being sadly serious, is I say, “You shouldn’t expect some of our leaders to understand personal finance. After all, we don’t teach it in school.” That’s one of my main irritations that we don’t teach any form of money or personal finance and forget high school. At any point, I think that it’s like 12% of high schools teach it. So it’s a subject that it’s tough to expect people to really know it but, hopefully, your book will play that role as well.
Jeff: Look, I’ve been on my soapbox. I’ve gone to state legislative meetings and pitched them on the idea of saving a few 100 million a year and helping poor people as opposed to pouring it into B and hedge fund fees and helping them buy apartments in Pari. But it’s like knocking your head against the stone wall, and I just get tired of it. I have taken the plunge and committed a lot of resources to writing this book. So I’m hopeful that things are going to change. I was just at the Baltimore Orioles game. I’m a little bit of a baseball fan. And they have the worst record in baseball. And yet, I’m sitting there at my seat in the upper deck. And there two sections over there’s a guy with a sign saying, “All is not lost.” So I think that’s a good way for us to perhaps end this conversation. Keep hope alive.
Meb: I got some ideas we’re working on that I think may help at some point. But this engine of disruption that’s kind of mauling over lots of industries, I think one of the biggest industries on the planet has potential to get in their sights at some point. So we’ll see.
Jeff: You have a sense of history. That’s obvious from looking at some of the people you talk to, and obviously your listeners do as well. So if you look at some other investment fads, if you want to call them that, such as Internet stocks in the ’90s, which shot through the roof, real estate, biotech, I mean, they all had sort of that going up to the moon cycle. And then, people sort of recognize that, wait a second, the value isn’t there, and then there was a bit of a crash, and then maybe they recovered. Some people say, “Well, why hasn’t that happened in private equity, Jeff, if what you say is accurate?” Well, it would if all the information was publicly available. But as I said, so much of what goes on in the business is secret, pay-walled, and confidential, that people that want to do a little digging, the honest, upright people in the investment business that want to do the best for their clients, they’re just finding it very hard to get the right information.
Meb: It’s a very simple concept is actually is that it benefits no one to publish subpar returns. So it doesn’t benefit the databases. It doesn’t benefit the industry. It only benefits the people who have great returns, which they’ll just publish them. On public funds, the beauty is they’re there. We have 12 ETFs. It’s like every single day, you can look up how they’ve done, and then you see the attrition in the “Morning Star” like the average mutual fund. Over the last 10 years, half of them closed. Like, it’s just like a massive amount under-perform a very basic index. And so maybe the legislation is that look, you have to publish your returns. And we need to open the kimono. And so if you’re going to be a private partnership focused on these, where particularly a public pension is investing in your fund, you got to publish full kimono. Some of these are like thousand-page meetings that they have.
Jeff: So let’s look over an example. So I looked at the state of Pennsylvania pension fund, and a couple of their private equity funds were horrible. They just totally bombed. And so I think one of them was Bain Capital. And so Bain Capital 8, the fund bombed. And so the pension fund was considering going into number nine. So you would say, “Well, 8 bombed. Why would you go into it?” I’ve asked people about that. Why would you go into a fund where after the last couple funds bombed, and it’s sort of a naive, immature response. They say, “Well, we think they’re going to do better next time.” For most investments like yours, running funds or whatever, if you bomb out, usually, people pull their money away. It just doesn’t seem to happen in the same manner in the private equity space.
Meb: Well, I love there’s a quote that says, “Rather than picking an LBO fund manager based on past performance, an institutional investor could have earned more by throwing darts blindfolded at a list of buy-out managers and made some new choices accordingly.” The old “Wall Street Journal,” like monkeys throwing darts, I love it.
Jeff: Yes, exactly right.
Meb: That would have been an apt discussion. Jeff, as we wind down, it probably sounds harsh to some listeners. But I think it’s a very fair… And if you think of it in the right way, it’s a very optimistic message, which is, look, let’s have transparency, and put all the cards on the table and be honest about the returns and what this industry does and make decisions from there. And I think that’s hard for a lot of people. But that’s the way, thankfully, the internet eventually has that effect on the disinfectant. Hopefully, eventually, we had retweeted or emailed out one of the minutes from one of the meetings years ago, and they got mad and stopped publishing them from one of the big and downwards. And so I tried to stay a little more in the background. But it’s an awesome book. As you look back on your career, you’ve been at some pretty different storage shops, doing all sorts of things, writing books, are there any memorable investments or deals that you worked on over the years that like stand out, in your mind, good, bad in between?
Jeff: I’d say probably the most interesting deal I worked on, say in the last 20 years, was an employee-owned newspaper in Pennsylvania. It was a strike newspaper. So you had it all. You had the corporate buyers. You had the employee unions. You had the different notions of what a value is. It was fascinating dealing in M&A context with instead of two corporate players playing off one another, there was an employee group that was rather fractious against the sober sort of corporate interests. I mean, I’ve done a lot of international work. And that is appealing because I was flying off to exotic destinations. I guess perhaps one of the more interesting ones was a deal in Thailand. And people just look at these emerging markets so differently than the way we expect business to be conducted here. But that’s something that has an innate appeal to a lot of people to see business internationally and kind of experienced different cultures. And I actually wrote a book about sort of my exposure to these exotic emerging markets in Asia and Latin America.
And I think from the point of view of investors, I mean, they shouldn’t just look at the United States or public stocks. They ought to look at some different investment categories, international bonds, or emerging market stocks. I mean, you got to be cognizant of the risks. I don’t really think that private equity in and of itself is evil or pernicious in some way. I think the business even if, let’s say legislation is passed by some miracle, and there’s transparency, and everybody can see what the numbers truly are, I don’t think it’s going to disappear. But as you sort of mentioned a few minutes ago, the fees will drop. So the fees will drop. It’s not going to be quite indexed on fees but say instead of being 2%, maybe the fee will drop to 1%. And then the profit participation would be much more oriented to the investor’s benefit as opposed to the manager’s. So these things have happened in other asset classes. But the secrecy and the confidentiality and the protections being given the business by government and media and by investment consultants, it’s just very hard to overcome. Like I said, time will kind of beat these things down at gradually, and in 10, 15 years, you might see a different landscape.
Meb: Not to be totally negative on the asset. I think if I had to pick a area, it would be kind of what you mentioned, which is, hey, if your PE fund focused on, I don’t know, Malaysian tech or Malaysian industrial or Pan African fund or something where like, there’s a possibility of real inefficiencies, rather than the just like well-studied, mid-cap U.S. market or whatnot, at least, that would be the possibility in my mind of out-performance. But who knows. Listeners, check out Jeff’s book, “The Myth of Private Equity” on Amazon. Where else can people find your other writings, what you’re up to, your thoughts? Any good home websites or places to go?
Jeff: I’m on LinkedIn like everybody else on the planet. I also have a website, jeffhooke.com, where you can look up my background and these books, but the books are all available on websites that sell books. This particular book, “The Myth of Private Equity,” is available on the publisher’s website as well, Columbia Business Press, but also Amazon, and Barnes and Noble as you pointed out.
Meb: Awesome. Jeff, it has been a blast, a romping tour through the depths of the private equity industry. Thanks so much for joining us today.
Jeff: Thanks for inviting me.
Meb: Podcast listeners, we’ll post show notes to today’s conversation @mebfaber/podcast. If you love the show, if you hate it, shoot us feedback at email@example.com. We love to read the reviews. Please review us on iTunes and subscribe to the show anywhere good podcasts are found. Thanks for listening, friends, and good investing.