Transcription
It's a money trap, right? The money's gone in, it's just not going to come out.
So, I should have about 3.6% weight in private markets. And but if I have a 15% weight or a 30% weight or god forbid a 40% weight, I am massively massively overallocated to these 12,000 companies. The S&P 500 constituents don't borrow a lot of money or or they borrow a lot of money, but relative to their market cap, it's tiny. Um they're almost completely unlevered. Um uh but these private equity deals are generally 50 or 60% leverage.
So what does it say about you that when the stock market's reaching all-time highs, you can't sell your company, right? Probably means your company isn't worth what you think it's worth. Should companies that borrow a lot of money be more risky and more volatile than companies that don't borrow money like or have cash on the balance sheet? Of course. What's a reasonable bankruptcy rate to expect in like a real recession for really small companies like that that have a lot of debt? I guess we 25%. It's like everything in our logical mind says that this stuff should be more volatile. And yet when you look at the uh um volatility of the NAVs, the volatility of the NAVs um is about where uh investment grade corporate bonds are.
>> Hi Dan, welcome back to Excess Returns.
>> Thanks for having me, Justin. You and your team at Verdad Adviserss put out some excellent research on a weekly basis on a whole host of topics like today's topic was investing in Japan and capital allocation. You talk about value investing a lot and you also talk about um sort of what what I would say sort of some of the hidden risks in the markets and various asset classes. And you've been a pretty vocal critic of private equity. Actually, in your book, The Humble Investor, you even have a chapter titled The Private Equity Bubble. um that's dedicated to sort of a lot of the topic that we're going to talk about today. And just for listeners, you can go to verdcap.com, get on their mailing list, and um you'll start getting their pieces of research on on a weekly basis, which are really good.
So, where we kind of want to start is there's obviously been a massive buildup in private equity over the last 20 years. Um and now there's new efforts to possibly bring private investments into ETFs. Maybe they're they're already out there. I know this is all kind of new and fluid in terms of these private investments getting into ETFs. And so we thought it would be a good time to sort of sit down with you, look at some of the misconceptions with private equity and the risks in private equity, how investors should think about sort of future returns in private equity, and just talking about the role that private equity kind of plays in someone's long-term portfolio.
Um, we're joined today by a guest host, Kaiw of Sparkland Capital. I know you guys go way back. I think you may have rode together on your crew team in college if I have that connection correct. Um, I was thinking maybe someday we could have like a concept two sort of competition and instead of uh instead of the humble investor, it might be maybe we can do an article called the humble humble rower. What do you think?
>> It'll be the even more humble investor after I schlonged by Kai's uh rowing prowess.
>> So yeah. So, Kyle, I'll let you kind of take it here. Thanks for thanks for helping out with us.
>> Yeah. Yeah. No, it's it's good. I'm I'm honored to be on here, Dan. Um it's good to see you, man.
>> Good to see you, too. Nice view.
>> Yeah. Thanks. Thanks. Um Brooklyn, not bad.
So, yeah. I mean, look, you have a you publish a ton of stuff, all really amazing. You've written books, you've written long form articles, uh, you know, weekly letter, which as you know, Justin mentioned is fantastic and everyone should subscribe to it. It's it's one of the things I read every every week on on Monday. Um, you know, one thing I like most about your work, Dan, is that, you know, a lot of these ideas are kind of timeless. They're universal. Your your principles, they transcend just like, hey, you know, here's my view on stock X. It's, you know, very applicable no matter what sector of the market you focus on.
So, one quote I wanted to start with was you said investing is not a game of analysis. It's a game of metaanalysis. So, just share with us what that means and and and kind of where do you come up with that idea?
>> Yeah. Uh so I think this is sort of a an alternative way of expressing the uh efficient market idea. Uh and the argument is that it's not what you think that matters, it's what you think relative to what everyone else thinks. Right? If if you think AI is a really cool technology and therefore you're going to make a lot of money buying AI stocks, you know, you've missed one uh crucial part of the ingredient, which is that other people have also figured out that AI stocks are good. And so, you know, you have to have a differentiated view in order to make money. You know, people call it a variant perception or right, something different um in order to make money or if you just think what everyone else thinks, I'm sorry, you're just part of the herd.
Um and I think that I would go even further and and this is one of my, you know, main arguments, right, is that in some sense, um the spectrum of beliefs on a given topic is indicative to you of the ability for you to make money, right? And if if there's what I call correlated beliefs where everybody thinks the same thing and you agree, you're really not going to make money, right? Like that's the worst case scenario because not only is what you believe priced in, but there's no sort of risk premium for believing it, right? Like um you know, think about uh think about a betting market where someone is, you know, if you know uh someone is leading in the polls by to win the presidency by 30%. Uh and you bet that they're going to win the presidency. Um, and you're getting that contract where you pay a dollar and if they win, you get a dollar in return because everybody thinks they're going to win anyway, right? You just can't earn any money that way, right? You have to take the other side of the bet that that person's going to lose. Maybe that contract's treading it. You know, you put a cent in and you earn a dollar if that person wins, right? Like that you have the option to make money. Now, probably the consensus is right if the polling numbers are are that far off. But, um, but you you you know, you have these ingredients that are necessary, right, for you to make money. One of the ingredients needs to be that whatever it is that you think can't fully be priced into the market.
Um and markets have a way of more than fully pricing things in um of of of sort of being over optimistic about certain things and overly pessimistic about others. Um and so my argument about sort of how to think about investing at at a baseline, right, is like first, right, start with efficient markets, right? Okay, own the passive weight, right? Be passive, right? That's sort of a good starting point. And then only take those active bets um where you believe that there's a metaanalytic reason that you're right. Not that you just think like, hey, it's 2020 and I think Zoom's a great stock cuz everybody's locked in their house, right? Like you need to have some perception that goes, you know, beyond that, right? Where you have sort of a unique view. And I think where that leads me to look for, you know, sort of in the same way as I just defined the odds in that betting market is to say, well, I want to look for my places that are going to be uh I'm the option to opportunity to make the most money are the things that people are most pessimistic about um or that are most capital starved um or both. Um or maybe even places that are really capital starved but actually no one's all that pessimistic about. They just don't even care. There's no one's paying attention. Uh and to try to find those types of opportunities um wherever they might be.
>> And so on the converse side, right, what are examples of things that everybody loves, there's plenty of capital and very few people are pessimistic about. Um and so that leads us into, you know, the the main topic as Justin mentioned of this conversation. Um how does this quote shape the way you look at private equity?
>> Yeah. So, so private equity is uh is sort of the dar or has been until recently and we should talk about what's changed. It's it's sort of striking how much things have changed in the last few months. Um but um but private equity has been the darling of investors eyes uh for the past decade. Um and if you look at um institutional investors um pension funds have about 15% of their money in private equity, college endowments 30%, elite college endowments 40%. Um so um you know the biggest the quote unquote most sophisticated investors uh love this um and if you do surveys of these people um uh they generally will answer on surveys that they believe almost 90 plus% of them believe private equity will outperform public equity.
Um and uh generally the margin the sort of median margin is by 200 basis points net of fees per year. Um so there's a tremendous degree of optimism. Uh and I think remember we uh I gave you those numbers like 15 30 40%. And I think perhaps the easiest way to understand private equity for me are just take this like bird's eye view is just to put a few numbers around this right and I think people often misunderstand private equity and there's some misleading numbers around it. So I'll give my sort of very simple bird's eye view of it which is you know there are 500 companies in the S&P 500. Um those companies have an aggregate market capitalization of about $50 trillion. Okay. So all the biggest, best, most profitable companies in the United States and in the world are public.
Um and they are very fairly valued on a daily uh liquid basis. Uh and you can own the best companies in the world by buying the S&P 500 index for free. Um now let's say you want to own the next 2,000 companies because they're about 2,500 public companies in the United States. Those next 2,000 companies, right? Four times the number of companies uh have an aggregate market capitalization of a little over $2 trillion. So uh and that's because the average market cap of an S&P 500 constituent is hundred billion dollars and the aggregate market cap uh of a Russell 2000 constituent is under two billion right so you you there a lot more of these companies but they're a lot smaller and so the market size is tiny it's about 6% of the size of the S&P you four to 6% of the S&P 500 right um uh now you get into private equity okay private equitybacked companies uh represent they're about 12,000 private equity back companies, so six times the number in the Russell 2000.
Um and they have an average market cap of about 300 million or so, which means they have an aggregate market cap about 2.5 trillion, 2.4, 2.5 trillion, right? So, let's call it about the same size as the Russell 2000, right? So, yes, there are 12,000 companies in the private equity and there are 2,000 companies in the Russell 2000 and 500 companies in the S&P 500. Um, but those 500 companies are massively bigger on every metric you could possibly think of than the small cap stocks in the Russell 2000, which in turn are almost 10 times as big per per company um as the companies that are owned by private equity. So the first thing you need to be thinking of is that um private equity is first foremost investing in very very small companies.
Um and so what should you expect from small really small companies, right? Just intuitively, right? If you're comparing your local dry cleaner or pizza shop uh you know to uh to uh Microsoft right like what should be your intuition right like well your intuition is that the smaller company should be a lot riskier right it's a lot more likely to go bankrupt um it's much less diversified it's probably much lower margin because it doesn't have any scale advantages and probably it just hasn't um it's certainly in terms of almost any definition of quality is going to be lower right like Kai you write a lot about intangible value right like think about like how many patents does your local dry cleaner have versus how many patents does Microsoft has? Like uh what kind of talent can Microsoft hire versus what kind of talent can your local dry cleaner hire? Like on every different metric, right? You're going to think the better companies, the bigger companies, the more scaled companies, companies more intangible value, coming with more assets with higher margins are going to be the large public companies. And these small companies are uh are are going to be um yeah, there might be a diamond in the rough here and then, but these are generally sort of businesses that exist, you know, fighting for uh attention and market share in in these very fragmented markets.
Um and I think what's kind of scary, right, is we think about that math and you you sort of do it right, you you get to a number where you say, okay, gee, well, you know, private equity is, you know, five or 6% of the size of the S&P 500. Um and then you say, well, you know, what's the typical, you know, equity allocation of a endowment or foundation or pension fund? And you kind of get, okay, probably 60%, right? Probably 60% equity, 40% bonds, I don't know, something like that. Um, so I'm going to say that like 60% time 6% should be in private. So I should have about 3.6% weight in private markets. And but if I have a 15% weight or a 30% weight or god forbid a 40% weight, I am massively massively overallocated to these 12,000 companies. Why am I massively overallocated to these companies? Right? What is it about these companies that got me so excited um that I would put all my my money such a large overweight on the smallest lowest margin um uh companies?
Um and so you say well what else is different about these companies sort of in aggregate and the other thing that's different about them in aggregate is they're massive borrowers. Okay so by and large these big you know the S&P 500 constituents don't borrow a lot of money or or they borrow a lot of money but relative to their market cap it's tiny. um they're almost completely unlevered. Um uh but these private equity deals are generally 50 or 60% levered. And so for that 2 whatever trillion of equity, there's also another 2 point something trillion of private credit that sits in front of it in the capital stack. Uh and so these firms that are uh very very small are also very levered. Uh and so you know, you could argue that they're going to have a higher beta to the market because they're they're levered. Um uh and so you know that's sort of the bet that all these pensions and endowments and foundations are taking that that if they buy really really small low margin subscale you know lowquality businesses but they lever them hugely um that they're going to win over time.
Um and I think that's sort of the bet that all this sort of weighs on like are those 12,000 companies can they bear all this debt and all this equity are they worth it? Um uh or perhaps have we all gotten a little bit too excited about this crap?
>> Yeah, when you put it that way, it does sound a little bit like illogical. So, what might be helpful, I think, for the audience here is let's step back in time and and kind of walk me through the advent of the Yale model. Um and you know, how do we get to where we are now? Like this massive overweight does seem a bit odd. But I mean there there was must have been a reason historically that um you know the the elite endowments did overallocate to these asset classes and you know presumably have earned enough in excess returns to justify a continuation of that strategy over decades.
>> Yeah. What's that that wonderful uh that wonderful quote which I'm going to butcher which was what the wise men does at first the fool does at the end or something. There's some I can't get quite get the quote but um but uh but yeah so so there was a genius to the Yale model and and if you walk back to sort of the the birth of the endowment model of of of investing um and I'll go through some of the controversies but it's sort of fascinating right so you know the the typical um uh endowed institution actually was always very riskaverse historically and they had a huge amount of money in bonds um and after World War II the sort of pioneers of endowment investing started to say well hey gee why don't we own some equities like we shouldn't just have all of our money in bonds.
Like why don't we make a little money in B. So okay so in the 40s and 50s and 60s you know they started developing you know they they went from sort of 0% equity to sort of 60% equity uh and still 40% bonds. Um and then the 70s happened where both bonds and equities lost money for a decade because of stagflation. Um and so by 1980 there was this huge sort of u uh uh huge question among these endowed institutions of like well gee that sucked right like we thought our stocks and our bonds were diversifying they both lost money.
So these endowed institutions were desperate for something else to do. Um and so what they ended up doing is looking for quote unquote alternatives right? Like what what else could we do? Um and there were a number of sort of early thinkers. Um uh there was Jim Bailey at Cambridge Associates um uh there was some thinkers at the Ford Foundation uh and then there was um sort of later you know in the next five years after that Swson at Yale would adopt this sort of thinking and they basically said let's go and just find everything else that's not stocks and bonds that we can invest in to diversify our portfolio so the 70s never happened again sort of the great irony of that is if in 1980 you just bought the S&P 500 and 30-year treasuries you you'd have been fine right you didn't need any alternatives then it just turned turned out there was sort of like this point in time.
Um but uh but they did actually find some interesting things. So they started investing venture capital. Um they started investing in in private equity. They started investing in private real estate. Um uh which has been sort of the least successful because you know public REITs have just consistently done better. Um but um but uh the venture and private equity portfolios for these funds actually did quite well over the years. Um and if you think about why that is, um uh in the olden days, the private markets um didn't exist. Okay? So, you could go like if you wanted to raise money for your great new semiconductor company, like who are you going to raise it from? Like, like in 1980, like there was no venture capital yet. There was like you could go like to your buddy's rich uncle and get him to give you money for your semiconductor company. There's no sort of formal structure.
Um and so when these early people, the Excelss and the Sequoas of the world formed and said, "Hey, we're going to put some thought behind this and find every, you know, crazy genius who just left Intel and wants to start a new semiconductor company and we'll give him a little bit of money and, you know, I bet since there's no one else doing that and we're pretty smart and can kind of filter these people, um that's going to be a good idea." And it was uh because no one else was doing it. And the private market similarly, you know, there were a huge number of, you know, family-owned private companies in the United States. And so, you know, these guys would fly to Cleveland and find a company that sold dog food and, you know, pro take the grandpa out for dinner and say, "Hey, could I buy your dog food company for three times last year's cash flow?" And he'd say, "I didn't even know anyone I could ever sell my dog food company and now you're offering me this huge lump sum. You great, I'll take it."
Um and and and so in the early days in public private equity, you know, private firms were trading at about a 40% discount to the public equity market, right? Huge gap um that could be arbitrageed and was over a 20-year period. Um and in the venture industry, you saw this sort of fund and lead to the '90s tech bubble and things like that um that were revolutionary in many ways, even if they caused a great financial crisis. Um and so you you know, this was all very interesting, but it hasn't been without its myths, right?
Um I think you look at um in the 2000s, um uh one of the big uh alternative assets of course was commodities and emerging markets. Um and uh you know Harvard's endowment for example our alma mater uh thought this was a great alternative asset and put 20% of their portfolio in a combination of commodities and emerging markets and emerging market commodities that essentially was a negative return for 15 years and a huge drag on the portfolio. So a hu a lot of these sort of alternative investments don't necessarily work out. There's no law that they have to.
Uh and I think what you're starting to see with private equity and venture capital is the sort of turning of the tide where so much money has flowed into them. Um and all of a sudden no money is coming back and people are starting to get a little worried.
>> So, a couple questions there. So, first of all, you mentioned money has flown in has not come back. So, what's going on with distributions right now?
>> Yeah. So, so typically private equity distributes about 30% of NAV a year. Um but recently those distributions have dropped up down to about 10% of NAV. um which is the lowest since 2008.
Um and if you haven't noticed, we're not exactly in a recession right now. We're in probably a stock market reaching all-time highs. Everyone's a bulant. So, what does it say about you that when the stock market's reaching all-time highs, you can't sell your company, right? Probably means your company isn't worth what you think it's worth or there's something wrong with your baby.
Um and I think that's what start people are starting to to worry about. Um and so why can't they sell their companies? Why is the exit environment so bad? Um um and I think it's um you know you sort of have to go down in sort of the order of uh of what um uh of what um uh the typical exit path is. So about 50% of exits in private equity are to other private equity firms.
Um so uh that exit channel is very dependent on fundraising. Uh and private equity fundraising peaked three years ago. So private equity fundraising has stepped down, stepped down and stepped down again. Um and as private equity fundraising has stepped down, right? Like if you know the 2025 vintage funds just in aggregate have like hundred billion dollars less to spend than the 2020 vintage funds and the 2020 vintage funds are trying to sell to the 2025 vintage funds.
Um the 2025 vintage funds just can't pay as much, right? Because they just don't have as much money. And by the way, debt's a lot more expensive. Um so the math on their LBO looks a lot worse than the 2020. It's like trying to buy houses from people who bought their houses in 2020, right? Like it's hard. um you're, you know, you're just not going to be able to pay the prices those people paid with the mortgage rates those people borrowed at.
Um uh so that's a problem. Um and as that sort of spiral continues of, you know, harder exit, worse returns, lower fundraising numbers, that that's that's a problem that can get worse. Um the next exit path is strategics. Um so you just sell to some bigger company that's already public. Um and then for whatever reason, the M&A market has been pretty slow.
Um and I couldn't tell you exactly why. I mean, I'd say one of the reasons it seems private equity is really focused a lot on sort of vertical software, a vertical SAS software, probably 40 50% of the deals and some something like that. Uh, and maybe there aren't a lot of public buyers who want to integrate like the auto dealer vertical SAS company or whatever and take that public. It just doesn't fit. Like why would Salesforce need to buy that? They don't.
Um, they're trying to build sort of a general platform. Uh, and then finally, there's IPOs. Uh, and uh, my my sort of quip about the IPO market is the natural buyer um, for a private equity deal that goes public is an active small cap manager.
>> Maybe an active midcap manager. And I sort of joke, have you met any active small cap managers, right? I mean, like there's just not enough of them to buy this stuff. I mean, it just doesn't exist. I was at a an small cap uh manager conference uh with with a lot of friends that that I I like and and one of them said uh uh, you know, did you know that in the worst year for private equity fundraising you know 700 private equity funds closed and uh the other small cap active public equity manager said, oh 700 funds closed god that's brutal for all the employees and uh and the guy said, oh no no in private equity when you close a fund it means it launched because in the mutual fund world all he could think of was was, you know, closing fund closed, fund clo fund shut down, another fund shut down, right?
Um, but I thought it was such a funny moment, right? Like that's their exit liquidity in theory. Um, and so I think it's not a surprise that amidst those traditional channels drying up, we're seeing this massive increase in 401k, add it to the 401k, sell it to retail.
Um, uh, it's happening at precisely the time that traditional fundraising channels are declining, declining quite sharply. One of the um interesting or I guess perceived benefits of investing in in private equity is like lower volatility. You know maybe that you know you get a 15% return and a 10% standard deviation but you and you had some data in one of your articles which we'll put in here about the volatility comparison. But first talk about this idea of volatility volatility laundering.
>> Yeah. So I think again you you've got to start with that sort of intuition that highle view I started off before is like what do we know about private equity? We know they're really small companies, really small. And we know they're really levered. So, are smaller companies riskier or less riskier than larger companies? Well, they're more risky. Should they be more volatile or less volatile than large? More volatile.
Uh, and we know they borrow a lot of money. Well, should companies that borrow a lot of money be more risky and more volatile than companies that don't borrow money like have cash on the balance sheet? Like, of course. Like, everything in our logical mind says that this stuff should be more volatile. And yet when you look at the uh um volatility of the NAVs, the volatility of the NAVs um is about where uh investment grade corporate bonds are.
Um and so if you're using volatility as a proxy for risk, you're thinking of my private equity portfolio is an investment grade bond that has equity like positive equity plus 200 basis point returns. That's the sort of in naive institutional investor perception.
Um and I think as we talk about 401ks or could we put private equity into ETFs, um I think people are sort of wondering, you know, what's going to happen? And I think, um, what's really interesting and and sort of I stumbled upon it cuz a friend pointed it out to me is that there happened to be a bunch of public private equity funds that listed on the London Stock Exchange. So, not like the management company like Blackstone has been publicly listed, but like think of like Blackstone Fund 10 as being listed or in this case, Harborvest has a lot of uh funds that are listed, a fund that's listed on the LLC. So, it owns underlying private equity vintages.
Um and so you can actually say directly like, well, how is the volatility and performance and how have these publicly listed private funds done? Um and the answer is that they've done a little worse in the public markets, but um they've had volatility that's just crazily high. And the NAVs um the reported navs are just as volatile as other private equity navs, right? They're about 10% per year standard deviation.
Um but the market price uh is 24%. And the delta is the discount to NAV. So it turns out that people have various reasons uh for discounting more or less, right? In bad economic times they discount the NAV more. In good economic times they discount it less. Recently they discounted it a lot more. The last two or three years they've public public equity markets have grown a lot more skeptical of value at net private equity valuations at the London stock exchange as any indicator.
Um and so I think this provides a nice answer to the question like how volatile is private equity? Well, it's about 24% annualized, right? So think of it as a little more in the Russell 2000, right? Which makes sense. Smaller companies in the Russell 2000 should be a little more volatile. Uh, let more leverage to be more volatile maybe a 1.6 six beta, something like that, right?
Uh, and so I think that sort of for me answers the question of, hey, when you put private equity into a listed vehicle, u, you know, if you do that in the US through some sort of public ETF that owns private assets or whatever it might be, what's going to happen? You're going to find that a lot of people are pretty skeptical of this stuff, certainly public equity investors, and so they trade at a steep discount to NAV.
Uh and that that discount to NAV is so volatile um as to drive the uh make the pricing of the aggregate asset uh much more volatile than the navs. Um and you obviously see that in in secondary markets as well which have variable discounts. But I think this is sort of the cleanest way to see it and to build an expectation for what's going to happen if we see daily priced private assets. Right? It's going to turn out that investors just don't like that stuff because it's opaque. It's high fee. They don't know what it is and so they're going to discount it.
>> You had mentioned a few minutes ago that something changed in the market recently. What what are you referring to private companies getting in ETFs or something else?
>> Uh so I would say that uh that if you look at the um discounts to NAV at which these London listed private equity funds trade at um they've gone from 95 cents in the dollar in 2021 or so to like 70 cents in the dollar today. So the public perception or the public market perception of the uh discount uh you should you know pay to own private equity has gone way up.
Um and I think sort of that's coincided with um the drop in distributions um to NAV um which has been quite precipitous over that period and it's uh also coincided with I'd say sort of the headlines that we've seen of Yale selling a big stake in their private equity of stakes uh of other big GPs starting to sell out of private equity.
Um and I would say the the mood has shifted um quite precipitously um uh in talking to endowments and large investors where you know 7 8 months ago private equity is still the apple of their eyes. They were all excited about what new funds they were getting into what co-invest deals they were underwriting. It was all they cared about all they wanted to talk about to the extent that like you had buddies that worked at these places that were doing like private equity deals on the side like buying a soccer team in Ireland and like you know like it was just like everyone wanted to do it.
Um and uh and now all of a sudden uh everyone seems to have lost interest and you talk to them and say, "Oh, you know, I think our allocation to private equity maybe a little overallocated right now or you know like you're like I've never heard you say you were overallocated before." Right? I mean like these are words that press uh that that sort of respond to bad numbers and precage bad numbers to come.
Um and I think it's it's quite interesting to observe that uh that mood shift which has been quite uh quite striking to me at least. It seems like it might be going in the other direction, but I'm just curious on do you think that like lockups generally are helpful in the sense that by not getting you know daily marktomark you know valuations that behaviorally you're able to and since investors aren't seeing those in real time maybe when things are down they're not overreacting and making bad decisions. I mean a lot of private equity isn't happening at the retail investor level. I get it. But I'm just kind of the point about lockups and sort of being a positive for investor behavior. Just want to get your thoughts on that.
>> Yeah, it's an interesting it's an interesting argument, right? Um and uh you know, it's it's funny. I um you know, my dad is a longtime Boglehead Vanguard investor. And so all of all of his kids were all you know, we all have our Vanguard accounts. I love Vanguard.
Um and our sort of one of our sort of family mantras, just never check your account. Like the the best thing is if you forget your login, you know, like set up some auto invest and forget the login, right? Like actually like bogalhead investors are actually really good long-term investors if you just look at the behavior of Vanguard investors. Like this stuff about like retail investors like being flighty or whatever is actually kind of BS. I depending on the type, right? Like of course there are some type of them are but if you look at the Vanguard you know investors they're actually remarkably uh long-term in in nature um and actually institutional investors I've found to be quite fickle um uh for a whole variety of reasons they get a new CIO every six years who changes the portfolio um you know every 3 years they shoot the dead horse in the last three years etc etc um uh so I I'm not sure that I I sort of buy the the framing that um that institutional investors uh need this less than than retail investors ers.
Um but I think the um, you know, uh, the the idea that lockups are are helpful to people, I don't I don't think seems seems off base. But I also think in terms of learning, it's a challenge because, you know, we learn. The more feedback we get, the more we learn. Uh, the less feedback we get, the less we learn. And so, if you're getting your feedback on a 10-year cycle, you know, how much are you going to learn? You might have three cycles in your working life.
Uh, how much have you learned? Whereas, if you're investing on like monthly numbers, right? Like you're going to get a lot of cycles. Uh and I sort of joke, you know, you think about the pod shops which have been immensely successful. Uh and sort of the critique from fundamental investors, oh, they're so short-term focused. They're always focused on next quarter's earnings. And to which my response is, well, maybe next quarter's earnings is all anyone can predict. Like maybe that's where all the alpha is. Like maybe there's actually no alpha past a quarter. Yeah. Like I'm I'm not saying I necessarily believe that, but it's at least worth considering, right? Like and so the private equity investor is saying like I have a really long-term perspective, right? Like I'm thinking out four or five years. Well, who the hell knows what's going to happen in four or five years? Like, what's the point of even thinking about four or five years? Like, I don't know. Like, I'm not sure that's a good investment idea. Like, I think you should be really laser focused on the things you can predict, which tend to be the things that are relatively short-term in nature.
>> So, Dan, you mentioned kind of a turning point, right? That that we've, you know, the past few years have seen, you know, fewer distributions from profit funds. We've seen these funds start to trade at a discount, at least on the data available to us. um you know at least anecdotally in your conversations with endowment foundation leaders you know kind of a a sentiment that you know maybe we kind of took things too far. So, how does this all play out, right? Like, you know, Justin, you've mentioned the idea of, you know, potentially um you know, retail channels showing interest. You know, the discounts may suggest otherwise, but um that could be one way. Does it end in like a a bang or a whimper, right? Do we see a crash as people rush for the doors or do these things just kind of trade a little bit like, you know, lower returns over the next say decade?
Um but, you know, there's not, you know, a huge reckoning within the industry.
>> Yeah, I so I'd say on the first I think I think it's a uh it's a money trap, right? The money's gone in, it's just not going to come out, right? It's not it's going to trickle out and that and people are not going to be happy with that. They're already unhappy.
Um uh and they've loved this stuff so much for so long that they're sort of it's in the early days of reassessing their love affair. Um but they're starting to starting to realize that uh it's not quite as beautiful as they thought it was and maybe there are some issues and um and maybe we used to be a little skeptical, right? I mean, we're sort of in that early stage, but we're there. We're definitely there.
Um uh and the question I think is um is there a bankruptcy cycle or not? Right. Okay. Cuz in a bankruptcy cycle, that 2 plus trillion of private credit um uh and that 2 plus trillion of private equity that's on the back of these 12,000 small companies, right? Like what's a reasonable bankruptcy rate to expect in like a real recession for really small companies like that that have a lot of debt? My guess would be 25%, right? So I I could see 25% of private equity back companies going bankrupt in a in a 2008 like scenario.
Um and if that happens, it's just going to be incineration of capital, right? I mean that that type the industry can't sustain that. Um uh and the ones that don't go bankrupt are going to be limping. Um and it might even be higher that because I think you know depending on the numbers you look at a pretty high percentage of private credit is already picking with payment in kind where they don't pay cash interest. They just add money to the debt. And so in a bankruptcy rate environment, right, I would expect 100% of the things that are picking today to go bankrupt and then some percent of the things they're not picking to, you know, have to pick and therefore go bankrupt as well. So it could be higher than my 20 25% rate.
Um, now if we don't get a bankruptcy environment, right, like we haven't had a bankruptcy like we had sort of minor bankruptcy environment in 1516, the sort of industrial energy and recession where a lot of industrial and energy stocks went bankrupt but nothing else did. Back to you know 2011 2012 maybe it's some stuff in Europe go bankrupt and then 2008 in the US but really for the US we haven't had a bankruptcy cycle since 2008 so it's sort of perfectly feels pretty plausible to say gee nothing's ever going to we're never going to have a se never going to have a concentrated moments where lots of things go bankrupt um and therefore that would be sort of more the sort of fizzle where um because it's private credit you just amend and extend the loans and it's just a money trap the money that went in never comes out uh or it comes out 20 years later at a lot lower rate than you thought it was going to come out.
Um uh and I think it just depends on the macro which is of course impossible to predict.
>> So maybe making things a bit more positive since that was very gloomy discussion we just had. Um so you know look it it sounds like your view is that there's not a ton of value in private equity and other things.
So let's go back to the public markets. You mentioned that you know small cap value small cap stocks have been you know generally unloved. And you know per your kind of the initial statement around meta analysis you know one would you know surmise that that might be an interesting place to look for value. you know you wrote some interesting papers around this idea of like leverage small cap value like replication of private markets into public stocks right to the extent where you can characteristic match maybe you can't do it perfectly but in general you know these are roughly the same companies just some happen to be private some happen to be public talk to me a bit about the discrepancy there talk to me about your original paper and then how your thoughts have evolved over time on that topic.
>> Yeah. So our original idea was that you know if you look back from 2011 or so 2013 2014 you know back when I wrote this paper um you know the historic returns of private equity been quite good.
Um and so the question is well what drove that and and my argument was that you know you're you're sort of adding three premium together you're buying very small very illquid things. Um you're using debt and and that's a more of a controversial so I'll talk about that.
Um and uh and third um generally you're buying cheap. So, you know, private equity in the 80s and 90s was was was small cap value on steroids. It was leveraged small cap value. Um and unsurprisingly, it did pretty well during a period where small cap and small cap value did well. Private equity did really well. Like they just put, you know, uh used leverage, put uh you know uh pour gasoline on the fire.
Um uh and so my argument in that original paper was like you don't need to put this in a private vehicle. There are tons of companies in the public markets that have these characteristics. They're small and liquid. um they're uh cheap uh and they're levered and actually you can't get cheap in private markets anymore.
Uh and you're you know you you you know maybe you could a little bit in 2011 or 12, but you certainly can't now. And and you you really haven't been able for 10 years. Um it's all expensive because there's too many companion chasing those same 12,000 private companies. And so it's just hard.
Um uh uh uh but that was sort of the original thesis. you know, can you go out and find these small cheap levered firms and um does that sort of earn a return premium that looks like the private equity return premium? Um and I'd say um you know my sort of from actually investing in this stuff over the last few years, what what I've what's sort of happened um and you can never predict the way the world's going to work.
Um uh but initially when when I sort of did this work uh and I started to look at well where are you know things that are just cheap on an absolute basis and the vast majority of them were international. So, uh especially in Japan, a huge percentage of the cheapest things I could find were in Japan at the time I started my fund. So, I started investing a lot internationally.
Um and I'd say, you know, you rewind or fast forward, you know, 10 years, what's sort of happened is that small cap and small small cap value has worked quite well internationally. It's earned a premium to the market. It's outperformed the market benchmarks. Um and if you have been a small cap value investor internationally, you're generally quite happy and proud of yourself. Things sort of worked out the way they were supposed to work out on paper.
If on the other hand, uh, you were a small cap value investor in the US, um, all of a sudden, um, you believe that you are the world's worst investor known to man and that all your ideas are stupid and dumb, um, because the small caps are trading at the biggest discount relative to, uh, large caps ever in history and the value stocks are trading at the largest discount relative to history. So you combine those two and you've just been annihilated.
Um, and so I think the, um, interesting thing, so what sort of explains the difference, right? I'd say, you know, in, uh, in the US, um, the small cap market, um, is really, you know, it's, it's almost, it's four markets, okay? It's the bank market, the biotech market, um, uh, the energy market, and then everything else, um, uh, and, uh, and that's sort of the way the, and then in the international markets, it's almost all everything else. There just aren't, aren't any biotechs. There aren't really that many banks. All the banks are big and there's not really any energy. So energy, biotech, and banks are what makes the US small cap market different from international small cap markets, where almost all the companies are industrial, you know, consumer discretionary, healthcare, right? That's all these random industries. But in the US, small caps are really concentrated in these three industries. So we have to think about sort of what's happened with those industries.
Um, and I think it's been sort of each has its own idiosyncratic story. Um, in energy, um, energy had this tremendous boom into 2014 and 15. Uh, and then sort of a bust, a crazy bust, and then no one's really been able to make money in small cap energy stocks since. Uh, it, it just seems like those shale fracking companies are, you know, the stereotype is that they're capital incineration machines. They require a lot of investment to go and drill the wells and the, the oil that comes back just never seems to quite justify it on a return basis. So that's just sort of been a wasteland.
Then you're at the banks, which, um, you know, all these small cap regional banks just don't seem all that exciting. And then they had that big blow up when First Republic went bust, uh, and then they kind of recovered, but it's just been not a very exciting place to be. And maybe that's because there's not enough M&A and you, they haven't been able to reach scale or whatever. Um, and the interesting models are always the riskiest. Um, uh, and then biotech is probably where I've been spending most of my time because I think it's so interesting.
Um, the biotech market has just been annihilated. Like absolutely shellacked. Um, I think it's down 60% from the peak. Um, um, I think, um, you know, I'm sure most of the concentrated dedicated biotech funds are massively shrunk, if not going out of business. Uh, it's, it's probably the, the biggest pain point place of pain in the small cap equity market right now. Uh, and I think for me, that's, that's one where I've been spending more time because I think my sort of intuition is that we're going through a period, uh, of biotechnological advances that probably is similar to Florence and the Renaissance, right? This is like a moment in history where we're making massive advancements in biotechnological research. We're learning so much about the science and yet these stocks are just dog crap, right? I mean, like trading like worse than small cap energy or small cap banks.
And so, uh, what I've been working on for the last few months is trying to figure out, you know, whether there's something to do there, which is related in some ways to the work you do, Kai, and intangible value because when you're talking about a biotech stock, they don't have assets and they don't have revenue and they don't have profit. So, you have to figure out a way to think about value beyond that. You know, what does value mean? And it has to be intangible value. It has to be the quality of the patents or the quality of the research, the quality of the drug and development or the quality of the people. Um, and so that's been a fun, fun area of learning from your research, Kai, of, of how to think about, uh, valuing intangible assets and thinking about there being value because that's the only thing you can do in this sector.
>> Yeah. Look, it's so interesting, right? You think about where we are today and the overall kind of speculative cycle. AI is booming, crypto booming, biotech not so much. And it's kind of weird because you historically people have kind of put those three things kind of in the same category. These are kind of the major platform shifts in technology. So why is biotech not getting recovered? That's an interesting puzzle that maybe you'll figure out. But I, I completely agree with you, of course, that, um, you know, with these sorts of companies, you can't take a traditional value lens, you know, the cash flow based, you know, price of book, whatever, um, for these sorts of small cap names.
Um, one, one question actually that's a little, that's related to your, your point is, so you mentioned that, and this is really interesting, that the inter, there's a compositional issue, right? Where the international value, um, strategies have worked, um, because the, the index is composed primarily of your kind of standard small cap names, um, where small cap value in the US has not worked because of, because of, you know, these three categories of things that have not yet worked. And there's a fourth category. So this fourth category of the non-biotech, non, um, you know, bank, non-energy names. Has, has small cap value worked in that sub-sector of US small cap value?
>> You know, I, I, I'd have to break it out, Kai. I can't honestly give you a good empirical answer. Um, I would say, like, what I can tell you is that value in the US, um, worked, um, from COVID until the release of batch GPT, and other than that, has not worked. So I think the other way to sort of look at, um, small cap value in the US, or at least how it's traded recently, is that it's almost entirely a sort of cyclical play, like an early stage recovery play. It seems to certainly work in those times, but it just feels like impossible to make money other than those moments.
>> Well, I, I think it would be interesting too, to look back historically at the composition of small cap value stocks and see how that has changed and morphed over time. Like maybe 40 or 50 years ago in this country, like it was a much more diversified set of names and so you know, you could maybe see why there would be maybe a more powerful value premium signal there versus where we are sort of today. So that's very interesting.
Yeah, there's also been a set of sort of economic research I've followed and I, I haven't been able to fully tie it, but, um, the, the, the idea is that the US has experienced this sort of dampening of the business cycle, that, um, that the US economy is just less volatile. Um, and to some extent, what value does best with is like volatile cyclical times where like people are randomly panicked about carpet manufacturers and then carpet manufacturing is fine the next year and you make a lot of money and then they're randomly panicked about hoses and then the hose industry recovers and like that. That's sort of a, like random cyclical variation is sort of what what made, um, uh, value work. Um, and if you're in an economy that's just seems less cyclical, where there aren't bankruptcy waves and there aren't sick cycles, um, and then you're sort of just stuck with these random sort of weird industries, you know, I don't know.
>> It's hard to think through.
>> Let's change gears just for one final topic, Dan. Um, and I guess it is related, right? So, you're saying, you know, we're not seeing enough crises. We're not seeing enough like collapses idiosyncratically in certain sectors. Um, well, let's talk about the, the opposite of that, bubbles. Um, so your, your colleague Brian Chenonoa, who you know, college classmate of ours, um, recently wrote a, wrote up an interesting paper about, you know, there are a couple themes here, but the kind of takeaway was that, you know, bubbles are kind of a necessary part of innovation. Um, so what do you think about that idea?
Yeah, it's, uh, you need to let a thousand flowers bloom, right? I mean, that every innovation wave, um, you, you need people, uh, you need speciation before you can have selection, uh, in evolutionary terms. And, uh, and so what do you need to create a massive amount of new companies? You need a massive amount of speculation in risky ventures, um, to create that speciation, like that capital availability and access to capital is the lifeblood of new company formation. And so, and it's why the US has been so innovative, right? Our venture capital sector is so great, right? Even if all, even if 99 out of 100 of these companies fail, the one that wins is like a transformational thing for the country, right? Like think of the impact Amazon or Apple or Google has had on the economy or our daily life, it's incredible. And these are all these sort of venture-backed companies that America has that other countries don't have.
Um, and so I think you start to see, like, yeah, bubbles, excessive optimism, um, fuel innovation. Um, and that innovation is great for the economy. Um, but at the same time, most of the innovative companies fail. Um, and so it's a double-edged sword. Um, and I think that, um, you know, that's sort of the way I think about, you know, we're living in one of these rare times. We, we really are. I, I think you have to step back and say, like, this, like Vienna for classical, Vienna in the 18th century for classical music, or, or England in the early 19th century with the steam engine, right? That we're living in that for tech, right? Like it's hard to argue that we're not, right? Like think about the developments we've seen, internet, mobile technology, cloud technology, AI. Like, holy smokes. Um, we are living, um, you know, in a time when, you know, an Elon Musk or, you know, these other people who are like, they're going to be in the textbooks like Thomas Edison or Ben Franklin, right? Um, and so I think it's, um, it's, it's, you know, both possible that that's true and that some of these areas are bubbles, right? That there's just too much capital that's not going to get paid off, uh, and, and both of those things can be true and actually beneficial, uh, in the long run to the economy. It's always easy to, uh, you know, look back in hindsight and say, like, you know, we went through the.com bubble, it's like, oh yeah, that was a bubble, but, you know, when you're in it, you can't really see it, right? Um, so I mean, so do you, do you kind of agree with that, like Dan, when you're in one of these things, it's, it's hard to know?
>> I think, I think it's, um, uh, it's, it's easier to know when you're in one and hard to know when it's going to end, you know? I mean, I think everyone who said that we were in a tech bubble in the '90s was right. They were installed too early. Um, and I think what's sort of interesting about this environment is, um, you know, it's paid for the last 10 or 15 years to be a futurist, right? Like if you grew up reading like popular science and basically like giving credence to every magazine cover and then like having the idea like I should bet money on all of this stuff, like, um, you've actually been a pretty good investor. Like that's been a good outcome. Like sci-fi fans have been the winners here. Okay. Um, because there's been, you know, like technology has surprised to the upside and its innovativeness. Um, and conversely, the skeptics, like, uh, me, who have said, "Hey, gee, you know, maybe we're, maybe this valuations are too high, or we're over our skis, or this technology is going to take too long, or it's not going to be as great as you think it is, right?" We've all been wrong, right? Um, and I, and I think at some point though, you know, people get conditioned and this meta-analytic thinking, right, like the correlated beliefs harden because things have been paid off, right? It's paid off to be an optimist about new technology. It's paid off to buy the dip. Um, uh, it's paid off to do all of these things which, sort of in a rational view, you'd sort of say, I don't know, like I don't know that that's a good idea, um, and I think that that builds up risk in the system. Uh, and so I think it's easy to see buildups of risk. It's hard to call when they're going to end, right? Like I, I actually don't think my, like negative private equity thesis is, like I don't know when you actually look at the numbers or like think through it rationally, um, it's not that controversial. I don't know, right? Like isn't it obvious to everyone that too much money is going into private markets, right? The only question is like when it's going to blow up or if it's, you know, like of course it's going to blow up at some point. Um, we just don't know.
>> How do you think about AI relative to other, I guess groundbreaking technologies? I know you're sort of like an avid student of history and you gave us some examples earlier, but, you know, are you thinking this is kind of a revolutionary technology that's going to really change the world and maybe even be bigger than the internet? I mean, I know this is a hard question to predict or answer, but just curious where, where you stand on it.
>> I think what's interesting about AI is that it's the first tech innovation that's capital intensive. Okay. Well, since fiber, okay, sorry, we've got the second. That's the second. Um, uh, but we know how the fiber one ended. And I think that the AI one is a similar problem, right? So, um, uh, so is AI amazing? Like, I'm obsessed with using chat GBT. I use it for everything. I like, I, I recently like, I showed up to work today in a new belt I bought and my colleagues like, "That's a cool belt. Where'd you get that?" I was like, "I don't know." I told JGBT I needed a belt and told it what I liked and it recommended it, so I bought it. I don't know. Like, I think this technology is so cool. Um, uh, so I'm a big fan of it. But on the other hand, you know, uh, the companies that are offering this service, um, uh, the tech companies, these big tech companies have gone from having about a third of the capital intensity of US industrial companies to three times the capital intensity of your typical US industrial company, right? So like, and, and like, by the way, like how fast do you think Nvidia servers depreciate is like an actually meaningful question now for a lot. Like those depreciation schedules really matter, um, to some of these companies' income statements and to the fate of our equity markets, right? Like, and to the fate of Nvidia, right? Like, is Nvidia, if these are like five-year depreciation lives and like Nvidia is probably pretty overvalued, and if they have one-year depreciative lives, like a lot of these data center companies are screwed, like, and somewhere, like someone's screwed. And I think that, um, while AI might be amazing, um, unlike like Google or whatever, like the Google search engine, which was basically like free to build and free, you know, like no marginal cost and massively profitable, like this is like turning, you know, every AI query is costing a massive amount of energy.
So it's almost a more traditional business and, and clearly a worse business model than what came before. It's like, I'd rather sell Salesforce subscriptions than sell AI because the Salesforce subscription, you don't have to recoup any capex. Um, u, and so I think that's the big danger to these hyperscalers.
>> Interesting. Yeah. So I think I know the answer to this question, Dan, but I do want to kind of like tie this all together. We talked about, you know, the demise of small cap managers. We talked about, um, you know, increasing market concentration, um, you know, being and compositions of the indices being potential drivers of, you know, a lot of the phenomena we've seen in the, um, in the equity markets both in the US and internationally over the past few decades. Um, you know, we just talked about AI and, you know, it's, I'd be remiss not to mention the fact that, you know, if you're an investor in the S&P 500, you've done really well and a large part of the reason why you've done so well is because of the, you know, astounding performance of the Magnificent Seven, Nvidia, Microsoft, Apple, Google, so on so forth, right? Which have increased to, I want to say 33% or around one-third of the market cap of the entire index, right? Um, and so, you know, now we're at this kind of interesting crossroads where we've seen this technology which, you know, you yourself as have said is an amazing technology, AI. Um, and so largely being invented and being developed at the labs associated with these firms. Um, you know, so to a large extent, the question becomes, is AI a centralizing or decentralizing force? Is it going to be the case that, you know, the three firms that have enough capex to be able to build out these models will have monopolies that will kind of endure forever, or is it the case that these things become commoditized and it's in fact going to be, you know, the long tail, the users, the appliers of these technologies that get the boost? So, how do you see kind of this AI trend playing into the many things we discussed over this past, you know, hour around, um, international investing, value, small cap? Um, you know, how does it all kind of tie together in your mind?
Yeah, I think we, we'll go back to a world where scale and monopoly or market dominance and scale, um, uh, in the last few years, because of these hyperscaler companies, like the, if you look at sort of the performance, you say, like, I just want to own the top five largest companies in the S&P 500, just own those, like for the last 10 years, you'd have done really well with that brilliant strategy. Okay. Um, but for the previous decades, horribly, because generally the story was like, these scaled monopoly players actually ended up earning like really low returns on capital and having a really hard time growing. And I think that the more capex you have to spend to produce your return, the more likely you look like the telos than that you look like Google. Um, so I think we're just sort of, it's a sort of a back to the future moment where the laws of economic gravity and cost of capital are sort of returning. Um, and we live in a world where these, you know, look at the salaries Mark Zuckerberg is paying these AI, you know, researchers. Like, I don't know, it seems crazy to me. Like, I don't think anyone can be worth that much. Um, but I think when you think that, um, we're designing like artificial general intelligence, like any capital spending is worth it. Um, so if that's your philosophy, like, do you think these people are likely to be overspending on capex or under spending? Like probably overspending. And so that's going to come and bite you.
>> Guys, this has been an awesome conversation. Thank you very much, Dan, for joining us. Um, Kai, thank you for helping me. I'm really glad I pulled you in. And, uh,
>> Yeah, guys, um, great discussion. Thank
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