Con­trar­ian: Th­ese three as­set classes are over­hyped

Austin American-Statesman - - BUSINESS - Paul Sul­li­van

We re­cently passed the 10th an­niver­sary of the col­lapse of Lehman Bros., a flash­point in the fi­nan­cial cri­sis. The econ­omy has re­bounded since then and the stock mar­ket has risen to record highs, but a feel­ing of cau­tion looms over many in­vestors.

One of them is Dan Ras­mussen, a con­trar­ian in­vestor who has mar­shaled data to ar­gue that three of the most pop­u­lar as­set classes for high-net-worth in­vestors — pri­vate eq­uity, ven­ture cap­i­tal and pri­vate real es­tate — are not as de­sir­able as they seem.

“I want to give the ad­vis­ers the in­tel­lec­tual am­mu­ni­tion to al­low them to say, ‘No, I’m not go­ing to put money into th­ese strate­gies,’” said Ras­mussen, found­ing part­ner of Ver­dad Cap­i­tal in Bos­ton.

Here is Ras­mussen’s ar­gu­ment for cau­tion in three ar­eas:

A model past its prime

Dur­ing the fi­nan­cial cri­sis, Ras­mussen worked at Bain Cap­i­tal, a lead­ing name in pri­vate eq­uity. One of his jobs was to col­lect data on deals by Bain and its com­peti­tors to de­ter­mine why some had done well and oth­ers had not.

The more prof­itable deals were the least ex­pen­sive ones, he found. The cheap­est 25 per­cent of deals ac­counted for 60 per­cent of the funds’ prof­its. The top 50 per­cent ac­counted for just 7 per­cent of prof­its. The dif­fer­ence was the price paid for the com­pany.

When early pri­vate eq­uity firms bought rel­a­tively small com­pa­nies at a dis­count and loaded them up with debt, the amount of lever­age on the com­pany was still about four times the com­pany’s earn­ings be­fore in­ter­est, taxes, de­pre­ci­a­tion and amor­ti­za­tion, or EBITDA.

Pri­vate eq­uity firms con­tin­ued to ap­ply this strat­egy, but they were pay­ing more for the com­pa­nies, and con­se­quently the amount of debt was ris­ing to more than six or seven times EBITDA. With lever­age at 10 times EBITDA, Ras­mussen found, a com­pany’s free cash was al­most all go­ing to­ward debt ser­vice, and it was nearly im­pos­si­ble to be prof­itable.

An in­con­sis­tent pat­tern

The ar­gu­ment against ven­ture cap­i­tal is less nu­anced. Top pri­vate eq­uity funds are still de­liv­er­ing high re­turns, but ven­ture cap­i­tal funds have largely func­tioned as what Ras­mussen calls “a rich man’s lot­tery.”

He cites data from Cam­bridge As­so­ci­ates show­ing that ven­ture cap­i­tal has un­der­per­formed the S&P 500, the Rus­sell 2000 In­dex and the Nas­daq over the past 15 years. And he ar­gues that those ven­ture cap­i­tal firms that built big names of­ten did so with a few spec­tac­u­lar in­vest­ments.

Any ven­ture cap­i­tal­ist will ar­gue that the big win­ners make up for all the bets that did not pay off. Ras­mussen em­pha­sizes how dif­fi­cult it is to find funds that are go­ing to con­sis­tently make win­ning in­vest­ments.

Higher-fee draw­back

Ras­mussen draws a dis­tinc­tion be­tween real es­tate owned by pri­vate eq­uity firms and real es­tate in­vest­ment trusts. And for him, the dif­fer­ence in re­turns comes down to fees. A REIT typ­i­cally charges a man­age­ment fee of less than 1 per­cent. A fund that owns real es­tate will charge a typ­i­cal pri­vate eq­uity fee, which can be as high as 2 per­cent to man­age the money.

But real es­tate owned in REITs, he said, could be a good buf­fer for anx­ious in­vestors be­cause they have a low cor­re­la­tion to tra­di­tional eq­ui­ties given their stream of rental in­come. They’re also less risky, he wrote, than his fo­cus, small­cap stocks.

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