Last week I actually put on big boy clothes and dress shoes and ventured to downtown Orlando to take in a presentation sponsored by the CFA Society here in Orlando.
I am not a Chartered Financial Analyst, and I have something on the order of zero interest in devoting a few thousand bucks and three years to get a certificate telling me what I know about picking stocks.
I figure I can let the results reveal that story for me.
I have to admit that they really do host excellent events with good speakers, and last Thursday was no exception.
Dan Rasmussen of Verdad Capital gave a presentation on private equity and private equity replication strategies.
I have talked to Dan numerous times since I first read his paper “Leveraged Small Value Equities” back in 2015.
He has developed a strategy replicating private equity returns without the high fee structure that delivers outstanding long-term returns.
The backstory on his research is fascinating.
What Investors Miss When Looking at Private Equity
Dan was working at Bain Capital, and he was asked to research how private equity delivered high returns and why Bain, in particular, was very good at accomplishing it.
What he found was that all the gains for Bain – and every other private equity firm – were primarily the result of size, valuation, and leverage.
To put it simply, the high returns were from companies less than $200 million in value that traded for less than seven times EBITDA and had lots of debt but were paying it down.
Best of all he found that this strategy could easily be replicated with publicly traded companies.
He discovered that small-cap stocks at low valuations which were levered but were paying down debt reduced a little over 25% a year from 1963 to 2013, albeit with a pretty high level of volatility.
I replicated the system he used in his paper and found that over the last decade using this method would have produced similar returns for aggressive investors willing to adopt the approach.
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It is one of the screens I run every week looking for potentially high return bargain stocks.
Dan also talked about something he sees going on in the private equity industry that he finds concerning.
After an extended period of outperformance, private equity has become the favored strategy of many institutional investors including pension funds.
More money in the space means more cash is chasing a limited amount of potential deals.
To get deals done, participants are paying up for deals, and we see transactions done at 10, 11 and even 12 times EBITDA.
In the tech-centric private equity funds, multiples can be twice that level.
That could spell trouble for private equity investors going forward.
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This is a scenario I have seen many times in the last 30 years.
It’s like an ecosystem in many ways.
The forest starts as a meadow, then it grows, and small critters flourish. This attracts predators and the whole system flourishes.
Eventually the forest becomes too dense with too much underbrush for smaller animals to hide, so the predators leave.
Mother nature then corrects the excess often with a fire, and the whole process starts over.
Strategies that produce high returns like risk arbitrage, internet stocks, macro strategies, and relative value systems flourish for the first to use them.
Then they attract too much capital that distorts valuations, and the whole system ends up burning down with massive losses.
Everyone abandons that style of investing, and eventually, it becomes wildly profitable once again.
Given the trillions invested in private equity right now, this could indeed be the scenario that plays out.
That’s potentially horrific news for pension funds, endowments, and other large institutions that are overly reliant on private equity funds to generate higher returns in today’s low return world.
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It could also be a problem for the broader market as the increased risk of private equity funds is being ignored, and the leverage levels are way too high.
It won’t be a problem for those of us who do not own private equity funds, but instead use the low-valuation, small-size strategies that the funds used to deliver those sky-high returns initially.
We don’t have to raise multi-billion dollar funds that pretty much force us to pay higher prices for larger companies.
We can do what the funds can no longer do.
Using the numbers based on cold-hearted strategy I employ for Max Wealth and Heatseekers members can help us avoid making mistakes that put us at risk of blowing up and delivering high returns, no matter what happens to the private equity industry or big company stock buyers.
I am working on something special that will solve all these problems, and I can’t wait to show it to you. Stay tuned.
To the Max,