Does Private Equity Beat Stocks, or Nah?

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The general partners, which largely includes pension plans, other retirement accounts, unions, etc., At this point, net of fees, the returns that they're getting look a heck of a lot like index funds.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Joshua Rosner. He's a co-author on a book on private equity that came out this year. It's got Plunder in the title. Actually, there were two books that came out this year with Plunder in the title. It's complicated. We'll come to that. The books say that private equity is harmful to society. One of them says the investor returns stink too. There's plenty of pushback on both those points. That's complicated too. Listening in is our audio producer Meta. Hi, Meta.

Hi, Jeff.

There's no time for small talk. A lot to get to. Anything you can tell me in 2 to 3 words that's going on?

Watching British Bake Off.

I take it that's a show and it—

Again.

Oh, now you're disqualified. That's 4 words. I'm sorry, Amanda. I was gonna go with, uh, cut own hair. It's just now occurring to me that kind of a slow week for both of us. So maybe it's just as well that there's no time for small talk. I understand we have a listener question. Why don't we jump right into it? Who do we have?

We have a question from Ray.

Where's he from?

He doesn't say.

Sounds like California. Let's hear it.

Hello, Jack. This is Ray, and I really enjoy your podcast, and I learn every time I listen to it. Thank you. The question is rather short and simple. When I invest in Blackstone, Carlyle Group, or KKR stocks, what am I exactly investing in because it seems like they have high net worth partners and investors in the firm. So how is this structured with respect to retail investor buying 100 or 1,000 shares? Thank you.

It's a great question, Ray. Blackstone, Carlyle Group, and KKR— let's throw in Apollo Group. Those are all private equity managers. That means they invest in business stakes that are not publicly traded. They do so through funds. They have investors for those funds. But these companies are publicly traded, and that's probably something that's confusing for some investors. We're actually gonna talk all about private equity today, and hopefully by the end, you'll have a better idea of what these companies do. Meta, you were looking at a website of those cases where like two movies come out at around the same time and it's kind of the same movie or pretty similar. What are some examples?

There's so many. Armageddon and Deep Impact came out around the same time.

That's like it saves everyone from an asteroid or something like that. Yeah.

A team of astronauts in space type of thing.

Yeah.

There was also Antz and A Bug's Life.

Antz and Bug's Life.

Yeah. I mean, what are the odds?

Bug's Life was ant-based, was it not?

Yeah.

Don't hold me to that. All right.

All right.

What else you got?

Then there were The Prestige and The Illusionist.

Yes. Both classic examples of movies that I've never heard of. Go ahead.

And The Truman Show.

My favorite movie of all time. Took the place of Splash, which has been moved to number 2. But what's the same as The Truman Show?

EdTV.

Oh, come on now. Really?

Well, that's what the list says. Then there's Red Planet and Mission to Mars.

Now we're back.

Okay.

I'm going to give you an example now from the publishing world. Two books came out this spring, one in April, one a week later in May. They're both takedowns of private equity, scathing takedowns. The first was called These Are the Plunderers: How Private Equity Runs and Wrecks America. And the second is called Plunder: Private Equity's Plan to Pillage America. You're almost tempted to say there's some plunder pilfering going on here, but I'm calling it a coincidence of pirate metaphors. The Plunder book wins on cover art. It's got some crossed cutlass swords and a guy, a skeleton face with a pirate hat and a business suit and tie. But the other one, Plunderers, recently took a big lead on irony because KKR, one of those private equity firms, announced a purchase of Simon Schuster, the book publisher who publishes Plunderer. It means that private equity now has a tiny taste of the bashing private equity business. If you're not familiar with private equity, it's a form of financing. Just like companies can raise money by issuing shares to the public through initial public offerings or IPOs, they can sell stakes that don't trade on exchanges directly to big investors like pensions or other sophisticated folks. And PE firms are kind of go-betweens. They raise money, they launch funds, and they use one of several strategies. Buyout funds, those are the most popular. They buy entire companies. Sometimes they buy publicly traded companies and take them private. Then they maybe shake up the management, cut costs. Sometimes they add debt. Sometimes they improve operations or they otherwise try to improve the returns. Venture funds focus on early-stage companies. Growth funds buy maybe more mature companies that are on the verge of profitability. And turnaround funds buy weak companies. There are funds that put money into other funds. Those are called funds of funds. And then there are ones that specialize in buying stakes that other private equity investors are getting rid of. Secondaries, those are called. Fees are quite high. They are typically 1.5% to 2% of assets per year. That's way, way above what I would recommend someone pay in, say, a mutual fund. And they add to that typically 20% of the profits above a certain threshold. That's called a hurdle rate. The clients of these funds, they're called limited partners. They usually commit their money for 10 years. That's a few years for companies to put the money to work in deals, then several years for them to cultivate the assets and try to improve the value. And then a few more years to unload those assets. Maybe they sell them to other private equity investors. Maybe they sell them to the stock market through IPOs. They distribute the net winnings to their investors. That's private equity. It's been around in its modern form for about 4 decades, starting with Kohlberg Kravis and Roberts, or KKR, in 1976. That's best known for the 1988 takeover of RJR Nabisco for $31.3 billion. That was made famous in a book and film called Barbarians at the Gate. And it's still the industry's largest deal ever adjusted for inflation. The Nabisco deal marked the top of a buyout boom. Then came a crash in the junk bonds that had been used to fuel those buyouts. The next buyout boom was from 2003 to 2008, and that ended with a global financial crisis. The third and most recent boom started in 2011. But maybe it's already peaked. Over the past couple of years, rising interest rates have led to a slump in IPOs, which are used as deal exits for private equity. That's cutting into the ability of firms to cash in their profits and restart their fundraising cycles. The big firms don't just do private equity. They also do real estate, which is also looking a little wobbly right now. And they do private credit, which is thriving because banks are pulling back on lending amid tighter regulation. Private credit includes mezzanine loans. Those can convert to equity if a borrower defaults. The recent pause in activity notwithstanding, private equity has become very popular. Blackstone recently became the first of the firms to reach more than $1 trillion in assets under management. For years, private companies have taken in more investor dollars than public ones. Big pensions view private equity as a key part of their investment allocation. Here's Andrew Palmer. He's the chief investment officer at the Maryland State Retirement and Pension System.

For us, the private equity portfolio is one of our main growth engines, and it has two attributes that we think are really important for us. One is we do think it can provide better returns than public markets, and it has been our experience that it's better returns. It gets the better returns because The managers are good at picking sectors and industries in which to invest. And importantly, they can affect the outcome. If you're an investor in public stocks, you have no impact on the outcome. You can vote proxies and we do all that on the public side, but really have very little impact on what happens with that investment. In the private equity world, they are the owners and they drive change and they can make the businesses better in a transformational way. So we think those are important. The second thing is that because of its based on net asset value on an appraisal basis, it's not as volatile as the stock market.

So Andrew says the returns are good. He thinks it has to do with investor activism and he mentions low volatility. We're going to come back to that in a little bit. So what's the beef? Here's Joshua Rosner. He's a coauthor of These Are the Plunderers: How Private Equity Runs and Wrecks America.

Private equity now controls about 40% of all the emergency rooms and hospitals across the country, and their interest and their goal is to make as much money as possible. Well, healthcare has historically been understood to have a social purpose, and for most states, there used to be something on the books called the corporate practice of medicine that essentially made it illegal for corporations to own healthcare businesses because they The primary goal should be patient outcomes, not making money. We've eroded that. And so in the crisis, you saw significantly higher rates of deaths, morbidity within nursing homes owned by private equity. You saw hospital emergency rooms where the resident, or I should say an RA was brought in and you ended up with the customer the patient with surprise billing. You ended up seeing fewer hospital beds, fewer ventilators because of the consolidation and efficiencies gained in those industries. So those are some of the major ones that we saw during COVID But then you also have examples. There's a company in the boot heel of Missouri that was one of the last remaining large aluminum rolling companies left in America that Apollo went in, they bought with large amounts of debt, They special-dividended themselves the equity that they'd put up. Within 6 months, they had no investment left in the company. And then they ran it, frankly, to bankruptcy, laying off what was the employees at what was the single largest employer in the county, leaving the large unemployment numbers, wiping out the tax base, which was a third of the local school taxes. So that teachers were furloughed, textbooks couldn't be purchased. And so the implications and the problems, the circle of pain extends outward. And so that's sort of the type of examples.

Joshua mentions a specific case there involving Apollo and a company called Noranda. And we reached out to Apollo for comment, and a spokesperson there said that Noranda filed for Chapter 11 in 2016. That was after Apollo had exited the business, and it said that it did that along with nearly every aluminum company and a long list of businesses during the commodity crash. The spokesperson also pointed out that in court filings, Noranda's CFO defined the principal cause of the Chapter 11 filing as the, quote, sustained and dramatic decline in the price of primary aluminum. More broadly, Joshua also said that private equity in general has amassed a lot of market share in certain industries, and he says in some ways the industry is worse than the stereotype that was depicted by Gordon Gekko. That's the greed is good guy with the slicked back hair from the 1987 movie Wall Street.

The point is, ladies and gentlemen, that greed, for lack of a better word, Greed is right.

Greed works. That's because, as Joshua says, private equity has gotten so popular, there's so much competition for deals that it's no longer such a target-rich environment. And the industry has had to look in new places for returns. One of those places is in businesses that haven't historically been run with the idea of maximizing profits first, like hospitals. Another is in what Joshua calls last nickel businesses, like heavy polluters among fossil fuel businesses. Other investors are discarding those and private equity can get a good deal. He mentioned special dividends, and that has to do with the claim that private equity takes a short-term extractive approach to investing. It has to turn profits on its stakes quickly enough to be able to cash out its funds on time. It sometimes does that by borrowing heavily and then paying itself in the form of special dividends, and that leaves companies saddled with debt. Of course, private equity often takes stakes in struggling companies and sometimes turns them around. Joshua argues that private equity is harmful for America. He says it's not that great of a deal for investors either. He says recent returns have shown that investors can do just as well in index funds net of fees. We'll come back to that in a moment. The book also has some colorful history. There's a man named Eli Black who runs a conglomerate called United Brands, and one morning in February 1975, he heads to his office as usual on the 44th floor of what used to be called the Pan Am Building, just above Grand Central Terminal. And he takes his briefcase and smashes a hole in the window and jumps to his death. And as the book puts it, papers flutter to the ground, and on one of those papers is written early retirement, 55. Eli Black is 53. He leaves a son, Leon Black, who later works at the junk bond shop Drexel Burnham Lambert, and it falls apart during the junk bond bust. So Leon goes off on his own and founds Apollo, and he stayed there until 2 years ago after it was revealed that he had paid disgraced financier Jeffrey Epstein more than $150 million. I got one from the other book. It's not quite as colorful. It's about Stephen Schwarzman's 70th birthday. He's the founder of Blackstone. He was on this podcast either once or twice. I think it was on once, and then once we played a conversation that Barron's had with him at Davos. Anyhow, the book Plunder, not to be confused with Plunderer, says that at his 70th birthday party, he had trapeze artists, camels, and the cast of Jersey Boys. I guess the point there is that that's over the top. I'm not really sure where the line is on billionaire birthday party taste. Meta, what do you think? Over the top or?

I think just adequate.

Really? How would you feel about fire breathers, kangaroos, and the cast of Sweeney Todd?

Maybe for your 80th?

That makes sense. Well, There's a lot more criticism of private equity than I'm getting to here in the books. And in a moment, we'll talk with a defender of the industry and we'll take a closer look at the question of returns. Let's take a quick break first. We'll be back in a moment. Data is everywhere.

When orchestrated properly, it sings.

At Morningstar, we analyze and enrich data. Making it actionable and powerful for you. Morningstar, where data speaks. Welcome back. Okay, so we're talking about private equity and some criticism of the industry. Let's get to an industry defender. Here's Stephen Kaplan. He's a professor at the Chicago Booth School of Business.

To the extent that the deals at the company level make the companies more productive and post-Great Financial Crisis, they've been focused on growing the businesses. I think they make society better off. They make the economy more efficient. They direct resources to more productive assets. And that's exactly what you want in competitive world.

Stephen says the stereotype of private equity investors as pirates is outdated. He says today they're largely focused on improving companies.

What a lot of the private equity firms do now, and this was not true 20 or 30 years ago, it is super true today, is almost all of them have operating executives or experts that they work with, either, you know, as partners or as advisors And when they make an investment in a company, they are usually bringing in someone who knows the industry and trying to understand how do we make this company better. May involve cutting costs, but more commonly, are there new products? Is there a new strategy, new geographies? Is there digital transformation? Are there ways we can make this company more productive and grow it more? They are very, very focused on growth. So I think that's where a lot of the value comes from. It also comes from the fact that you have alignment. So there's a ton of pay for performance. The private equity investors are paid for performance with the carried interest. The CEOs they hire get more equity in the companies than, say, a similar-sized public company CEO will get. So there's incentives and then this focus on operational improvement, I think, is where the value comes from.

Stephen mentioned carried interest there. That's another term for those performance fees. Let me come to the matter of returns, and to do that, I want to sum up a debate in 2000 by two top scholars on the matter. One is named Ludvig Philippot, and he's at the University of Oxford. He uses the term alpha clause to describe the belief that institutional investors have that the money they put in private equity will outperform the stock market. Alpha is a wonky term for risk-adjusted returns that beat the market. And the Claus part, if we have kids listening right now, I just want you to hold your ears quickly for this next part. The Claus part means the outperformance doesn't really exist, you know, because there's no Santa Claus.

There's no Santa Claus?

You misheard me, Matt. I said there's no Alpha Claus. And that's according to Ludwig. He calculates that US-focused funds that had vintage years, starting years from 2006 to 2015, they turned each dollar invested into $1.60, and that, that is similar to index funds after the fees. He also said that by the end of December 2019, the performance fees that were due on those same funds totaled $230 billion, even though their performance for those funds appears to have been driven by just a broad rise in asset markets, including stocks, and not necessarily skill. He says if the performance reverses from there, all those performance fees will still be owed. For that reason, he calls private equity a billionaire factory, and he's not talking about the investors who buy in now. He's talking, for example, about KKR co-founder Harry Kravis worth an estimated $8 billion, or Carlyle co-founder David Rubenstein, $3 billion, Apollo co-founder Leon Black, we just mentioned him, $10 billion, and Stephen Schwarzman at Blackstone, $31 billion. Ludwig says that the industry needs standardization of investment contracts and performance reporting to help bring down the fees. Now, taking the other side of that is David Robinson at Duke University. He says that part of the problem with Ludwig's analysis is that it combines buyout funds with other assets like real estate that shouldn't necessarily be compared with stock indexes. His own work on long-term returns for buyout funds suggests that they do outperform by about 3 percentage points a year after fees. And he says that to the extent that buyout funds have struggled to outperform indexes more recently, that's because governments around the world pumped a lot of cash into asset markets starting around 2008. And that sent the stock market broadly higher, making comparisons for private equity more difficult. He sees that as likely to reverse. Okay, so who's right? One thing I can tell you is that investing is not like physics. You don't have laws that perfectly dictate future motions. Stocks have been around for 4 centuries and people still argue over how much they ought to return in a typical year. So you can imagine how much more complicated it would be for an asset class that's only 4 decades old and that has limited reporting and a lack of daily pricing. I don't think that investors should count on plump returns from here. Falling interest rates can no longer be counted on as a tailwind for dealmaking and for profits, and valuations are up. Here's Carlyle founder David Rubenstein from a conversation we had last year. When the buyout word first started, you would buy things at 7, 8, or 9 times cash flow. Now you're seeing people buying things at 13, 14, 15 times cash flow. Those higher starting valuations are important predictors for returns, much more important than the level of interest rates. That's what Stephen Schwarzman told us in Davos. What we've found over decades is the price of interest doesn't matter much. The price that you buy it means almost everything. Okay, so prices are up and that matters. And if we talk about risk, things get a lot messier. Sometimes private equity funds are sold as diversifiers for stock and bond portfolios. Companies will say if the stock market tanks, private businesses can do a better job of holding onto their value. But those business investments don't trade from day to day, so their values have to be estimated during long stretches between transactions. Clifford Asness, he's the co-founder of AQR Capital Management, which has hedge funds. Those typically buy traded securities and they sometimes compete for investor dollars with private equity. He accuses private equity of what he calls volatility laundering. He says the industry chronically understates the likely swings in the value of underlying holdings. The private equity industry says that it does careful valuations and that those do a better job than wild stock market swings of saying what their business stakes are worth. Asness calls that trying to sell a bug as a feature. This argument is academic. What investors spend is the money they get back once their private equity funds are wound down. Not the theoretical risk they incurred along the way. Andrew Palmer, he's the Maryland State Pension CIO. He says the lower volatility might be artificial, but he's not bothered by it. In fact, he says the accounting convention is helpful for running his pension. One thing about private equity is there's a very wide degree of variation in the returns you get from fund to fund and manager to manager. That helps explain why some investors are so happy with what they've got. But stock buyers don't have to feel left out if they fall short of the definition of accredited investor. That's what you have to be to pass the rope line for private equity. You have to show that you have sufficient income or wealth or sophistication to buy in. There's a Harvard Business School study that finds that ordinary investors can beat the performance of buyout funds using tools available to everyone. They can buy a small-cap value fund to replicate the style of buyout funds, then they can use brokerage loans to simulate the margin, and then they can use some homemade hold-to-maturity accounting to keep down their volatility. In other words, just don't look at the statements. None of that is an approach I would recommend. I'd stick with companies of all sizes and skip the leverage, but the point is taken. Ray, your question was about the private equity stocks, the shares of the private equity firms. Those are corporations. When you invest in them, you're hoping that they'll make more money. And the way they make their money is in the annual fees that they charge on their funds and those performance fees, carried interest. So the performance of their funds is obviously important to them for that reason, and because they want to bring in more money when they go to start new funds. There's a lot of nuance here I'm not going to get to. I think the private equity industry in general has a little bit of Warren Buffett envy. They look at Warren Buffett and they see He's got these insurance businesses that bring in this free float of cash that he can continually invest. He doesn't have to go out with hat in hand to investors all the time and raise cash for new investments. And so they're looking for something like that for themselves. They wouldn't mind getting into insurance businesses to bring in more cash. They really wouldn't mind getting into investor 401(k)s. There was a rule change during the Trump administration to let them in. Now there's some pushback on that. We'll see which way it goes. A lot of the future performance of private equity depends on regulation. These companies aren't regulated in quite the same way that mutual funds are, but they are overseen by the Securities and Exchange Commission, which has typically taken a light touch, figuring that these are sophisticated investors and they can fend for themselves. But with the talk about bringing in 401(k) investors, the SEC appears much more interested now. There are new rules in the works, including reporting requirements. I didn't say a lot earlier about the social impact of private equity, whether it's harmful or not to society, but I think that views on that matter a lot for how heavily regulated the industry will be going forward. Personally, I found some parts of these books compelling, like the ones that talked about some private equity firms driving prices higher in parts of the healthcare industry. I found other parts less compelling, like about how private equity is buying up single-family homes and driving prices higher for renters. It remains a relatively small player there. But the parts of these books that I found most compelling, especially the one called Plunder, the ones that dealt with the cozy link between private equity and politics. Private equity lavishes campaign donations on politicians from both sides. And there's an endless parade of members of Congress who go on to score cush jobs at private equity firms. I think if you're a lawmaker and you get a call from someone at one of those firms who used to be a boss of yours or a colleague, and that person asks you for a favor, and there's an unspoken message that when your time in Congress is done, there could be a well-paying job waiting for you, I think it makes for a strong temptation to come through for private equity. I'll give you one example of that. We mentioned carried interest. Maybe you've heard of the carried interest loophole. Those performance fees that private equity funds earn, that's how they make their money. That's income. But there's a tax loophole that allows for that money to be treated like capital gains, which are taxed at a lower rate. So there are some billionaire private equity players who pay lower percentages on their profits than the wage earners at many of the companies that they own. I'm not an Occupy Wall Street guy. I'm not an eat the rich guy. You want to have camels at your birthday party? God bless. But the tax loophole is indefensible, and people have said that for 15 years. I don't know anyone who sticks up for it, but every time it comes up in Congress for someone to do something about it, like recently during the Inflation Reduction Act, it just mysteriously goes away at the last minute. I view that as a bellwether for the industry. You want to know whether regulators are going to crack down on private equity? Look for the carried interest loophole to go away. If it does, it'll be the earliest warning sign that private equity is losing control of Congress. Maybe look out below for the share prices. For now, the outlook for private equity stocks appears bright. That's according to Evercore ISI analyst Glenn Shore. He says that rising allocations to private equity will help the whole business, that a rising tide can lift all boats. But he likes some boats more than others. His favorites are Apollo and KKR. Remember, they're relatively bigger players in private credit, which is thriving right now. Blackstone depends more on real estate. Glenn says that they're excellent at real estate, but demand for real estate is down and exits on deals will be harder to come by. He says that investors like diversification. Carlyle Group is less far along in it than the other firms. It could take years for them to build more exposure in credit or real estate. That company has a fairly new CEO. I think we have said, Meta, about all we should say on private equity for now. There's some other topics I think are worth watching. I think there could be more competition competition down the road. I'm intrigued that like Blackstone and BlackRock are similarly named because they came from the same company. They sort of separated and one does publicly traded investments and the other does private investments. But now BlackRock, that's best known for the iShares funds and for public investments. It's getting into some private credit and private equity type investments. There are other traditional asset managers that are doing that too. So you wonder if private equity is going to have more competition down the road. There's also a trend where some of the biggest and most sophisticated investors are skipping the middlemen. Instead of going through funds, they're just buying private equity stakes directly on their own. We'll see if that becomes a bigger deal down the road. Either of those trends and more reporting requirements, I suppose, could drive down fees for the industry. And I think I'll leave it there out of sheer exhaustion. Was this a 97-minute episode? What are we up to?

We'll make this into a 5-parter. It's a miniseries at this point.

I was just gonna ask, we could do it Dukes of Hazzard style where they used to jump the car over the thing and then they'd freeze frame it halfway through and they'd say, if the Duke boys can get themselves out of this heap of trouble, I forget how they did it, but we could do one of those type of deals. What do you think?

I don't know about that.

Where did I lose you? Dukes of Hazzard. True story. When I was a kid, we didn't have a ton of money. We had— and by not a ton, like no money. And we had a tiny black and white TV. And I used to watch the Dukes of Hazzard as a kid. And so I thought the car was blue. Then I went to school and I said, hey, you know how that show— and they got that blue car. And all the other boys were like, what are you, an idiot? The car is orange. That's— now that I think about it, that's a sad It's a sad note to leave it. You know, I, it's a happy ending because now I can afford color TV.

The end.

And that's an example of telling one last story that you really didn't need. Okay. I want to thank Ray for starters and Joshua and Steven, both Stevens, and Andrew and Jason and Glenn and David. Am I leaving anyone out? And Gordon Gecko. And thank all of you for listening. Meta Lutzoff is our producer. At her birthday party, she's having Alpha Claws, therapy goats, and the cast from The British Baking Show. Woohoo! Subscribe to the podcast on Apple, Spotify, and the other things, and you can write us a review. That's on Apple. And we'll see you next week. Data is everywhere.

When orchestrated properly, it sings.

At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar. Where data speaks.