Private Equity used to make money like bandits, this is how they did it

I came across Dan Rasmussen on Meb Faber’s podcast this week. Dan runs Verdad, an investment firm which seeks to invest in leveraged small value (i.e. low multiple) stocks. The research behind his approach you can find here.

In essence, Dan’s thesis is that the reason that private equity beat the market by 6% per annum after fees in the 1980s and 1990s, was its ability to:

  1. Buy cheap firms (i.e. less than 6x EBITDA)
  2. Use leverage to amplify returns

However, the industry has not outperformed the market since 2010.  Private Equity is now a massive asset class, with thousands of people scouring the globe for deals, which has driven up prices.

Average EBITDA multiples are now over 10x EBITDA. Adding 60% leverage to a 10x EBITDA purchase price (typical in leveraged buy outs), dramatically removes the margin for error.

The strategy (and analysis behind it) is very interesting. I won’t repeat the detail of Verdad’s methodology here but do listen to the podcast.

The investment approach seems smart. Unfortunately, according to Forbes, Verdad’s performance has been extremely volatile

Three years in, he’s got about 20 clients and just $20 million in assets. His returns have made a gold-mining ETF look stable. After an 86% net return in 2013, his fund lost 10% in 2014 and 22% in 2015. He’s up 26% this year, for a return since inception of 14.6% a year, compared with 11% for the Russell 2000 small-cap index.

Volatility like this is a massive turn-off for investors, particularly pension funds. I doubt this strategy will attract significant money unless the volatility can be reduced.

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