Contrarian: These three asset classes are overhyped
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.
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.