1883: Two and Twenty: Insider’s Take on Private Equity Investing - Sachin Khajuria

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Good morning, empowered investors, and welcome to episode 1883. 1883. Our guest today is a fascinating guest and he is the author of a book entitled Two in 20 how the Masters of Private Equity Always Win. And you know, my mom was here recently and my mom is a voracious reader. She just reads everything. Maybe I inherited my extreme curiosity, almost obsessive curiosity, I will admit, from my mother, who knows? But I sure wish I had her reading skills, I'll tell you that. She can read and digest things so quickly. I did not inherit that one, unfortunately. However, she was here at my house and after I interviewed the guest, he sent me book, or maybe it was before, I'm not sure. And she grabbed it off my bookshelf and said, I want to read this now. What does my mother have to do with private equity? Well, just about nothing. But she told me the other day she was reading it and she was fascinated by it. So she says it's really good. So mom's book recommendation there. Anyway, so we'll get to that in just a moment. But before we do. Wow. Okay, so speaking of private equity, I saw this article in one of my newsletters the other day and just wanted to share a little snippet of it, you know, despite its dismal track record. Now, this relates to the so inappropriately named Inflation Reduction Act. I mean, the government, well, really, Congress specifically should be sued for false advertising, right? Actually, the person in the government who labels these bills, right, like the Inflation Reduction act, we should have the right to sue them for false advertising. It's misleading, right? It's misleading advertising. If a company did that, they could get sued for it. And folks, I tell you, I know we all love to hate the lawyers, right? Because they make things way too expensive and all of this stuff. But the fact that companies have liability for what they do is what makes their products, in many cases not always products and services better. And, you know, it forces them to be legitimate and do the right thing. We certainly know that people will not do the right thing, sadly, given the chance. And companies do not do the right thing. They abuse the public, the marketplace, the consumers, their competitors, their employees, their shareholders, stockholders, all the time. It's absolutely pathetic. And the worst of it happens in the big business world because they hire the lobbyists to make the laws in their favor. Yes, we live in a kleptocracy. Is it a kleptocracy or a plutocracy? I think it's a little of both. They are slightly different. Look it up. But yeah, that's what happens. So private equity. So here's what happened as part of this inappropriate name bill. One of private equity's main plays is the leveraged buyout. Now that's really what we do as real estate investors. We essentially do leveraged buyouts. When we buy a property the way I recommend you buy it, we do an lbo, a leveraged buyout. You've heard me make this comparison for many, many years, and that's what we do. But in the private equity world, it's a little different. Okay, so the article says one of private equity's plays is the leveraged buyout or the lbo. Right? We heard a lot about this from the big corporate raiders who became famous in the 80s and, you know, on into the 90s and so on, right? Which involves borrowing huge sums of money to gobble up companies in hopes of restructuring them and then selling them for a gain. But the acquired companies, which range across just about every economic sector, from retailing to food to healthcare, housing, are often overloaded with debt to the point of unsustainability. They frequently slash jobs and benefits for employees, cut services and hike prices for consumers, and sometimes even endanger the lives and undermine the social fabric. Okay, so look, you know, that's all debatable, right? And this is what the Democrats came at Mitt Romney with when he was running for president. You remember all of this stuff. Not only did he put the doghouse on top of the family car when they were going on a trip with a dog in it, I guess. But he was an evil or is a evil private equity guy, right? And look, there's two sides to every argument. There's two sides to Every story because we have to ask life's most important question. Compared to what? Right? But we also have to think about the dogs that don't bark. And so had the private equity companies not come in and purchase these companies and unleveraged buyouts, what would have happened in the vacuum? In the absence of that happening, would the companies have continued to go along as zombie companies? Would they have failed and gone under? We don't know. It's speculative, it's hard to tell always. Right. But look, you know, we're hearing both sides of the argument. Okay, so the carried interest rule, that's the big tax break, right? That was preserved by the Democrats who supposedly hate big business. Right? But they're bought and paid for like Kyrsten Sinema and you know, all the rest. Right? So there you go. So the article goes on. Private equity firms presided over many of the largest retailer bankruptcies in the last decade. Among them Toys R Us, Radio Shack and Paid Shoe Source. Well, look folks, were those companies going bankrupt anyway? I mean, that's the question, right? Resulting in nearly 600,000 lost jobs according to a 2019 study by several left leaning economic policy advocates. Okay, and look, you know, I don't know, is this just creative destruction? You know, Joseph Schumpeter is like my favorite economist because of that whole creative destruction idea. I think it's really valid. It's what capitalism does. So everything is up for debate. We all know that. But let's look at it when it comes to real estate. Here is the real estate connection, folks. Other investigations have shown when private equity firms buy houses and apartments, rents and evictions soar. When they buy hospitals and doctors practices, the cost of care shoots up. When they buy nursing homes, patient mortality rises. You know, look, I don't know if you can make that connection about patient mortality. Especially because did the age of the residents change? I mean there are so many factors. It's so complicated, you know, you just can't paint with such a broad brush like that. But what I will tell you, as I have told you so many times before, is that these institutional players that are becoming a larger and larger part of the rental housing industry are good for you as investors. Why? Because as the article points out, rents soar. They are much better at optimizing their portfolio for higher rents than you mom and pop investors are. Actually I should say we mom and pop investors because I'm one of them. I'm not an institutional investor by any means. I'm just a little mom and pop. Look, they do A much better job of rent optimization. They use software. They are relentless about squeezing every last dollar of Y out of their portfolios. And rents are sent by comparison. So when they are set by comparison, your rents are increasing faster than they did in the past. Now, we've seen rents increase at an incredible clip recently, and I'll tell you something, folks, you ain't seen nothing yet. Rents are going up a whole heck of a lot more. Mark my words. Mark my words, rents have tons of upward price pressure under them. So you're going to see rents increase a lot more in the coming years. That is a foregone conclusion. I can, you know, I'm literally betting on that myself. Okay. Quite specifically with my own portfolio. So this is good for you. Right? You know, it obviously causes different factors and dynamics in the market, as we know. All right. I wanted to talk all about negative interest rates and all that kind of stuff, but as usual, you know, we have to get to the interview today, but I do want to say that today we have our Empowered Investors Zoom meeting for Empowered Investor Pro members. And we are talking about 1031 tax deferred exchanges today. If you want to talk to me a couple of times a month, sometimes weekly, directly where you can talk to me, it's a two way discussion. In our Zoom meetings, join Empowered Investor Pro. Just go to empoweredinvestor.com, become a member. This is by far the best deal in the investing world. Just a very low annual membership fee and you're in all of those Zoom meetings. You've got the social network platform, which by the way, we just redid the platform and I absolutely love this new platform. But a lot of you existing members have yet to sign up and accept your invitation to our new social networking platform. So please make that a priority and if you need help with that, reach out to us and we will get you taken care of there. But we've got this great new platform. It does a lot more, it indexes the content much better and we have a whole slew of upcoming things we're adding to that platform. We've got so many videos in there, articles and resources and most importantly, people, your fellow Empowered Investor Pro members that you can network with and who you see on Zoom several times a month when we have our Zoom meetings. So be sure to go and join that empoweredinvestor.com and let's go ahead and get to our guest and talk about 2 in 20 how the masters of private equity always win.

It is my pleasure to welcome Sachin Kajuria to the show. He is an expert on private equity, something that is not talked about quite enough. He's the author of the new book that is taking off very nicely entitled appropriately 2 and 20, because that's the typical fee structure. How the masters of private equity always win. Satchin, welcome. How are you?

I'm very well. Good morning. How are you?

It's good to have you. And you're a former partner with Apollo and they are a big player in the private equity world, is that correct?

That's right. That's right.

I think they own University of Phoenix. Right.

I think they have a bunch of educational investments. They've done very well in a number of fields, including that.

Yeah, good stuff. Well, before we dive in, and I'm really looking forward to it, by the way, into the world of private equity that is somewhat obscure, I'd like to just ask you your thoughts on the broader economy, markets, stocks, real estate, whatever, and then maybe talk a little bit about how we got to this point where the, the whole economy is so financialized, even people's homes have become a financial instrument. This is, I don't know if this is a good thing, but it is what it is. So yeah, just what are your thoughts, Sachin?

Absolutely. It's a pleasure to be here and be able to communicate with your audiences. So let's start with the macro economy. So if we zoom out a little bit from the day to day talk of inflation, interest rates and is there going to be a recession? How do we really get here? We had the financial crisis, which seems like an age ago, and the authorities, monetary authorities, fiscal authorities, not just here in the United States but also across the world were pumping money and liquidity and financial support into the system to help people cope with what was going on with the financial crisis that involved saving certain industries, that involved certain institutions, disappearing banks and so on. And this period ushered in a kind of low interest rate, accommodative financial conditions decade really. And although we had bumps along the way during that time, we kind of got used to the cost of borrowing being very low, if not in some cases kind of nearly free. And we had negative interest rates for a. In some parts of the world, if you remember, we all kind of got used to it. And that includes, I think, big business as well as individual investors as well as specialist investors like private equity. And then the problem is each time you keep reaching for those massive tools of money printing and lowering interest rates and so on, there's an argument to say that they have Less effect each time you do it. And also that you're not necessarily running out of room. Because in theory you can just keep printing money, I guess, although it would have consequences, but also that it has side effects, it has other effects. And of course, as asset prices being lifted so much in the S and P, if you look at all asset prices really by this wave of liquidity, everyone felt a little bit like a genius when prices are going up and the Fed is coming to the rescue and all of that. And then you have these horrible shocks like Covid. And now in this year, you have obviously the terrible war in Ukraine and you have supply issues and you have inflation cropping. The thing to think about is that during this whole time, a lot of these structural issues that were building up in the economy haven't just gone away. We've been just focused on more existential stuff like having to shut down the economy to protect lives. It was like a forced recession, wasn't it? We sort of shut the whole world out down for a period of time and then started it all back up with another bout of liquidity and money printing and low rates and all of that sort of stuff. But what was underlying, which was some of the normal cyclical things that happen in the economy, so not shocks, but like cyclical things, they weren't really resolved. And so you now have a situation where that kind of wave of support is being withdrawn and the money printing is slowing and interest rates have to increase to respond to inflation. And you might find that bankruptcies start to tick up, restructuring start to happen. You're starting to see the odd bit of bad news from the major companies. We have. The odd results are underperforming.

Yeah, the layoffs. Don't let me forget. I'd really like to ask you your thoughts on the zombie companies of the S and P. There are a lot of them, but go ahead.

Well, there's lots of companies that, for example, had fantastic documentation. You could say in their favor that even if they run into trouble, actually the debt agreements are so favorable that they actually never get tripped up. Those covenants are so favorable to them that it's kind of like they just sort of exist without sort of crashing. And you don't have that natural process of if a business doesn't do well, it fails because it can cling on and that can be a good thing in some sense. It can give it more time. You certainly don't want jobs to disappear overnight. You don't want all of that to happen unless it really has to in some way. But you have had a lot of, I would say, reasonably artificial conditions which were forced upon us and probably necessary to cope with two massive shocks, which is at one bookend, the financial crisis and at the other bookend, Covid roughly 10 years apart. And we kind of got used to that decade. And so now as some of the sort of the punch bowl is withdrawn and some of that liquidity is being taken away, plus we have other things that things just keep getting worse, the shocks all the time. Whether you look at Ukraine, you look at what's been happening with supply issues, we start to see the underlying problems come through. And what we're finding is that the economy is still, I think it's pretty good shape. There's a lot of companies in great shape still. But confidence is weakening and cracks are showing here and there. I'd say they're not enormous cracks, but they're showing whether it's a credit crack here or it's a crack in consumer or business confidence there. And so I think what that does is that make people think about retrenching. And it kind of should be the opposite to what people are thinking because they're like, well, we got over Covid, we can go outside, we want to go on vacation, we want to buy that car, we want to take that flight. Or businesses are thinking, well, our business was shot, we've now learned how to partly work from home. Now how do we go back to investing, which maybe we did less of or none of in the pandemic? And then they're like, well, what's the outlook, though? What am I investing into? And so I think the problem right now is that as we've sort of, hopefully we're done with these major shocks, certainly financial crisis size or Covid size shocks, we're now facing a bit of a crisis of confidence. And that happens to fuel, I think, some of this volatility in the market. Because if you look at, if you have all your eggs in one basket, you're just in the public markets this year as an investor, whether you're a retail investor or an institutional investor, like a pension fund, you're not going to be feeling too great because you're looking at whatever 20% down or 18% down in the S and P, depending on which week you look at. And you're going to think, oh my God, where's all that great return I build up in 21? It's kind of all evaporating or evaporated in 22. And so where I think that leads us as investors, as folks who want to try and save for retirement, like some of your audience, it leads us to think are there alternatives to just putting all of our money in the public markets? And that's why I like to think of looking at other kinds of markets, like private markets as a very accepted means and as a means of investing, as a means of saving for the future in private markets, really being opened up now not just to high net worths or ultra high net worths and big institutions, but also being opened up to more retail, to the mass affluent and then even going further into smaller checks.

And the reason that, so when you say when we talk about private equity, if you will, people, I think of the bigwigs, they think of Mitt Romney, they think of that kind of stuff. But there are many crowdfunding style platforms, I don't know if I want to call them crowdfunding as a legal definition or anything. But where you can invest in private equity deals, of course you can invest in a private placement memorandum with a buddy of yours or a friend or family member, whatever. What do you mean when you talk about, about that? Are you addressing that, that market that I just mentioned, those two?

I think it's all of that, but it's also feeder funds. There are companies that, and even banks that have all these feeder funds where they say, well look, if you wanted to go direct into that particular private equity firm, you'd need $5 million minimum yourself put in or maybe even 10. But actually we're collecting smaller checks from individual banking customers of ours. So if you got 100,000 or these days actually even lower, if you got 25,000 or, and I think it's going to get lower, those feeder funds are coming up and then you've got now talk of, and I think it's going to happen, the ability to invest directly as a retail investor managing your individual retirement account or helping direct your 401k with your employer's help or whatever, I just think in general the direction of travel is the checks getting smaller. And what that means is these things that you might think of as private equity, as the preserve of what you call the bigwigs, they're becoming more every day. And the way I like to look at it, Jason, is that they're not alternative, they're mainstream. They really are mainstream. And you're probably already a customer of private equity today. It could be your university like you said, or it could be your mortgage provider. It could be the breakfast cereal you eat or it could be components in the car that you drive. Or it could be any part of the economy, because private equity is invested across the economy. So you're probably a customer. You're almost certainly a customer in some sense. You could also be a supplier, you may also work for a business, could be a media business or any other business that is owned or has borrowed money from private equity. And so the more you think about it as mainstream, the more you realize that it's kind of just as common as if you're talking about public equity, just happens to be private. And so the thing that's important is to realize that, because it's everywhere in our economy and you are increasingly getting the opportunity to access it. Because unlike public equity, where a lot of it is passive Investing, index funds, ETFs, replicating an index, and so on, this is active investing. It's highly active investing. The reason it's active investing is it's a people business. You're relying on the judgment of experts to get it right. And that's why I think more people need to think about this. Because not only is it becoming an increasing force as an investment option for people of all kinds, but also they need to be educated about what it's really like. And they need to be educated about how they make that decision themselves, how they decide whether they're being adequately compensated for the risks that someone is taking on their behalf. So when they think about a portion of their investment portfolio, not all of it, of course. You don't want to put everything, you don't want to swing the pendulum from one end all the way to the other. But if you're thinking of locking up some of your capital because it's illiquid, you can't take it out straight away. You might be thinking, well, how do I make that decision? Which firms do I back and which firms after I learn about. They're not. For me, it's the numbers, but it's also what's behind the numbers. And that can also help you perhaps determine whether you feel those numbers are sustainable.

Are these deals typically the high risk deals that are startups and so forth, or is that just how most of them come about? But I mean, there are large, established private companies, of course, right. But are those available to the public market or. I mean, I guess, you know, for.

Yeah, the way to think about it. It's a great question. The way to think about it is venture capital typically deals more with startups and business plans and smaller rounds of funding for a super idea that may turn into the Next Facebook or Google or something, or Microsoft, but it may not.

And private equity tends to be slightly later stage, tends to be. And the way to think about it is basically what you're doing is you're buying or investing in an operating business or something is sometimes lending to it in some way. And you are helping that business when you go on the board, or you may have control or you may have a significant influence, you're helping the management of that business improve that business. It has to be improved. Why does it have to be improved? Because one day you're going to sell it it and you want to sell it in a better condition than you found it. Try selling any asset in a much worse condition than you found it and getting a good result. It's tough and you don't want to be there. So they're trying to improve these assets and that often means growing them. Probably a net increase in headcount. Maybe there are some personal changes, but probably a net increase in headcount. Most times I've found in 25 years of doing this, and once you sell it in a better position than you found it, you make a profit. Just like if you were buying a house and selling it off for a few years, making a profit, and then most of that money goes back to the investors and you take your share, which is on average something like 2 and 20 depending on the firm and the situation. And so it tends to be slightly more mature companies. And as an individual, the important thing to think about is you probably can't do this yourself. You probably can't ever access this kind of investment yourself. So do you want some exposure to some of those big deals you read about in the papers online? And does it make sense for your portfolio? And at this stage, I would just encourage people to think about it. I'm not saying rush out and do anything, think about it, learn about it before the choice is actually put to you as a retail investor, for example, and you know nothing about it and you have no idea how to make that decision and whether it's for you. So it is typically the bigger deals and it's about whether having a slice of that and what you're doing is part of your portfolio. But it doesn't necessarily mean it's a leveraged buyout. Like I said, private equity has evolved a lot. It could be something in a sister strategy like private credit, it could be infrastructure, it could be a commercial real estate opportunity. It could be investing in life sciences, it could be in commodities, it could be in technology, private Equity does all of these sorts of things now is not just doing the kind of buyouts you probably saw in movies from the 1990s. And so that's why it's important to learn about it and figure out whether it makes sense for you.

Yeah, your book implies that the private equity folks always win. You called it 2 and 20 and that's what people think of as the typical fee structure for a hedge fund. Tell us more about that and the title and who's winning this game and who's getting the mediocre return or losing the game maybe.

Yeah, so I mean, obviously 2 and 20 is. I would say it's a benchmark. There are plenty of funds that don't have 2 and 20. They might have 1 in 15 or they might have more.

Yeah, some charge more.

I think it's kind of recognized as a bit of an industry benchmark. It's a well known term not only for private equity, but other forms of what used to be called alternative capital, or I just call mainstream. Active management is kind of the acronym. I've come up with the book mam and this sort of fee model is constructed to two parts. You have a fee for managing the money and you could say 2% is quite high, but remember again, it's a people business and so you have to pay for these skilled employees. You're not replicating an index. Replicating an index. You're not using machines to just sort of trade automatically. But that's not why they go to work. They go to work for the thrill and the reward of the job. But the compensation they're looking for really is the 20% which is the share of the profit. In other words, they're aligned. And this is what comes to the heart of the industry, I think, Jason, which is you eat what you cook. And you'll see this time and time again in my book, which is the basis of this is that in private equity you are not an advisor, you are a principal. And in other words, you are a principal just like your investors really are principals. You're an active principal, they're a passive principal because they've given you money to invest. But you are a principal. And because you're a principal and you're aligned, that's why you want that 20% to work. So the incentive is key to making progress in the industry, I think, and for the industry to drive results. And so coming onto the subtitle, how the Masters of Private Equity Win. I'm not saying they all. I think there are firms and funds that tend to underperform cheaper investment strategies. You have a lot of people accusing private equity of saying, well, it doesn't create any value. I put some money in, it didn't give me anything. I should have just bought the S and P. Maybe for that fund or circumstance you were unlucky. Maybe you were right. There's plenty of criticism. When you look at Warren Buffett and all the magnificent things that he's done for investors over the decades, he'll look at the average fund and say, what does the average fund do against the market? I think that is a tough proposition for active management because there is quite a spread of performance. Jason But I think when you look at the better ones, and my book is really about how to identify the better ones, they do do really well and they keep doing really well and they keep growing, doing really well. And that's how they're the size they are. It doesn't mean it's only the biggest ones. You can have smaller firms that are in niches like technology that are growing at lower levels but still pretty huge. But there are plenty of firms that consistently do extremely well.

Give us some examples.

How do you pick it? So I'd say, look, some of the ones that I back, I'm not going to discuss details about funds or individuals or deals, but the major firms like your Blackstones, your Carlyle's in technology or Silver Lakes, these are outstanding firms in general that are producing very strong.

Can regular middle class people invest in these deals?

So I think that's the question, which is as access is being opened up, these opportunities are coming for the middle class and they may not come uniformly that you can invest in every product. And it's a question of time because before you had to be a certain sort of, what's called a qualified investor or particularly sort of so called sophisticated investor or have certain knowledge about the markets. But I think it's changing and retail is becoming a very important channel. And so that's not to say that the average middle class investor can just buy in today, I think that would be wrong to say that, but I think the access is opening up. So like I said before you had to have multimillion dollar checks, funds. Now you can go through a feeder fund. And the important point is the access points are lowering all the time. And if you look forward a few years, we're not just going to be looking at, let's say, let's have a 60, 40 split of stocks and bonds. We might be looking at saying for the average middle class Investor who maybe has a modest portfolio, but it's even more critical for retirement or college education for their kids or whatever that that portfolio performs. They May now put 20% of their capital locked up into this. So it's important to be educated.

I think, I think one of the big concerns here though is governance. You know, I mean, listen, Wall street is a scam. Most people think that and they've got a lot of evidence for it. And I don't blame them sometimes. We've all heard the scandal stories, but in private equity, they don't have this kind of regulatory oversight. So what about governance? What about investors getting ripped off? What about the CEOs spending the money away and other intermediaries and middlemen just skimming all the money off the top?

Look, when you're not in that world, it's a very fair question to ask. Is my money safe? Am I dealing with trustworthy people? I'm self made, I didn't come from money. And I probably asked the same questions when I had modest means myself, which was, well, I'm being asked to put money into this fund as part of this job or whatever.

It means a lot to me. And I'd say the same if my family was investing or friends from college or wherever. And so it's certainly fair to ask all these questions. I think you need to think about a few things. I think number one, if we level set this industry.

It'S not a casino and it's certainly not a scam. In the financial crisis and after you saw plenty of investment banks go bust, you saw lots of hedge funds shut down, how many private equity firms did you see close?

I don't know. Do we get that news? Do we even hear about that?

It would be all over the press just like, like every other major closure. And the answer is very few, kind of almost none. And so they tend to be quite stable firms. They're long term investing. Okay, that doesn't mean they all do well. But in terms of like, you know, blowing up and losing everything and some kind of scheme and all that, I just don't buy it. It's not true. You do find there's differences in performance. And that's really where you get to your second question, which is education and governance. And there are a lot of very smart people working on that question at the regulators in Washington at the firms. And that's why it's taking time. That's why you don't just open access tomorrow to the entire middle class for all these products, because you've got to get it right. You got to figure out how do we explain the risks in the way that people will really understand. You can give someone a 2000 page prospectus or a 500 page prospectus. Are they going to read it? Are they really going to understand it? I mean, these are really big questions, Jason. And so how do you make ordinary folks really get what they're putting money into it? There's a lot of good work being done and that's why I think it's taking time and it should take time for that to happen. You can't just download a private equity investment on your phone now. I think there's no app for that. I don't know about maybe some point in the future but. But should you be able to click and sign more easily as an individual investor? That's probably coming. But it's going to come with governance assurity. It's going to come also with education. So that's why I think ahead of all of that, it's important for people to get a perspective on what this industry is. Right. And what I think and others who are in the industry think are the characteristics of success, what they should be looking for. What are the sort of things that I look for? Even if I know the firm, you know, I ask the same questions every time.

Got it, got it. Give out your book and tell people where they can find out more about you. Or give out your website. Sorry, not the book, the books. In all the usual places. But website.

Sure. Well, the publisher's website is coming soon. It's not quite ready yet. It's going to be called 2 and 20.com but you can find it on the Penguin Random House website by just typing in 2 and 20 or my name. And of course it's available on all the retailers, Apple Books, Amazon, Barnes and Noble and everything else. And I think what I would really encourage people, if they have time, is the Kindle version is good. I think that the hardback obviously is a great way to just sort of sit and relax and read it. But the audiobook is also doing very well because it really hammers in the messages and Penguin Random House has got a great voice actor in the audiobook to sort of explain and narrate this sort of. That's where they can find it. And I hope it's of use to your listeners and it just helps them learn a bit more about private equity as these choices are coming up for them.

Excellent. Satchin, thank you for joining us.

Thank you so much. It's been a pleasure.

Five out of five for the Jason Hatland Podcast thanks to his teachings, I have no worries about my future. My future's bright and that for now, my family. I recommend the Jason Hatman team to anybody who is interested in financial freedom by way of real estate investing. 5 out of 5.

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