Is Private Equity a Low-IQ Approach to Finance?

I am faced with an intellectual dilemma and trying to resolve it. For me, it revolves around intellectual honesty above anything. I can't help but think that Private Equity is a lot of trite mish-mash with the industry growth stemming from statistical artifacts, leveraged beta, errors in institutional investor beliefs about persistence, high expected returns, diversification benefits, etc. (things that don't actually exist). I think PE is the goose that laid the golden egg on this forum, but it seems to me that not enough people comment about how benighted PE really is in the grand scheme of things.

In my mind, leveraged buyouts, at their heart, are no different from stock-picking ( I get the extra diligence and operational changes that goes into PE relative to public markets investing.). But at its heart, it is levered stock picking with massive illiquidity and no creative hedging options. I call it illiquid, long-only, levered, stock-picking (or ILL Stock-Picking, for short). Right now, I am seeing fundamental L/S equity investors get hammered time and again for lack of alpha generation. Yet, somehow ILL Stock-picking a la Blackstone and Apollo is the holy grail of alpha?

I compare this with alternative methods of investing/finance (stat arb, momentum, HFT.. even high-sample size areas like mortgages or commodities) and can't help but think that those forms of investing are more intellectually honest and not as riddled with empirical errors. Simulataneaously I notice that Blackstone is over twice as large by AUM as the next biggest quant fund and scratch my head. I understand that quant strategies may be harder to scale, but it seems like a labor market breakdown to funnel top talent and money to investment programs with questionable alpha generation.

Here is some scientific work to back-up the concerns I'm raising:

  1. Does Private Equity generate Alpha? - Here is how Eugene Fama, 2013 Economics Nobel Prize winner, would respond:

"We ... emphasize that if private equity managers have skill in choosing good investment projects and bringing them to fruition, the result is a return due to the human capital of the private equity managers. Labor economists would argue that this return goes to the human capital, that is, the managers. Talented private equity managers are the scarce resource here, not investors' capital. As a result, the fees of managers should be set so that private equity investors just get expected returns that compensate them for the high risks of the investments."

"Finally, because the returns to private equity investments have large idiosyncratic random components (in addition to high market sensitivity), a wide range of outcomes is likely purely by chance. It is then predictable that the lucky managers are anointed by investors and the media, and they are flooded with new money from investors, even when past performance is due to luck."

Source: https://famafrench.dimensional.com/questions-answ…

  1. Historical Performance - "Our analysis suggests that private equity does not seem to offer as attractive a net-of-fee return edge over public market counterparts as it did 15–20 years ago, from either a historical or forward-looking perspective. Institutional interest in private equity has increased despite its mediocre performance in the past decade versus corresponding public markets, and weak evidence on the existence of an illiquidity premium. Although this demand may reflect a (possibly misplaced) conviction in the illiquidity premium, it may also be due to the appeal of the smoothed returns of illiquid assets in general."

Sources: https://www.aqr.com/Insights/Research/White-Paper…, https://www.aqr.com/Insights/Perspectives/The-Ill…

  1. Performance Persistence - "The conventional wisdom for investors in private equity funds is to invest in partnerships that have performed well in the past. This is based on the belief that performance in private equity persists across funds of the same partnership ... Post-2000 we find little evidence for persistence in buyout funds, except for the lower-end of the performance distribution"

Sources: https://www.calpers.ca.gov/docs/board-agendas/201…, https://pdfs.semanticscholar.org/3c31/135608cf8cb…

  1. Ex-Ante choice of top-performing PE Firms - If you are betting on pre-identifying good funds to join, then take a look at David Swensen over at Yale. He has been unable to meaningfully outperform the Cambridge Associates average PE return for the past 20 years. For reference, Yale's 20 year historical return on its leveraged buyout investments is 12.1%, while the 20-year PE industry average return, during the same period, according to Cambridge Associates is ~12.32% (this could be survivorship bias, but still quite embarassing if you ask me). If Swensen cannot outperform the PE index despite probably having access to "top decile managers", then why do you believe you can pick a PE firm that will generate gargantuan returns without it being a statistical artifact?

Yale Returns: https://static1.squarespace.com/static/55db7b87e4…

  1. Is Private Equity Due Diligence Cognitively Feasible? - Here is an interesting paper than comments on attention and judgement. I am skeptical that the 100+ page CIM/IC materials can be cognitvely processed correctly.

"What do we notice and how does this affect what we learn and come to believe? I present a model of an agent who learns to make forecasts on the basis of readily available information, but is selective as to which information he attends: he chooses whether to attend as a function of current beliefs about whether such information is predictive. If the agent does not attend to some piece of information, it cannot be recalled at a later date. He uses Bayes' rule to update his beliefs given attended-to information, but does not attempt to fill in missing information. The model demonstrates how selective attention may lead the agent to persistently fail to recognize important empirical regularities, make biased forecasts, and hold incorrect beliefs about the statistical relationship between variables. In addition, it identifies factors that make such errors more likely or persistent. "

Source: http://www.dartmouth.edu/~jschwartzstein/papers/S…

  1. Executive Pedigree - "Our findings suggest that the 'best and brightest' do not appear to have a statistically significant edge when it comes to managing public companies. An elite pedigree-the type of pedigree favored by head hunters and corporate boards-is not predictive of superior management. One of the central rationales for Michael Jensen's campaign (increasing CEO pay by tying it to share price performance) appears, in retrospect, to have little empirical support. These credentials, however, are significantly overrepresented in the CEO biography database. The elite credentials thus benefit the individual, but there is little evidence that these credentials benefit shareholders."

Source: https://verdadcap.com/archive/do-mbas-make-better… , https://verdadcap.com/archive/is-ceo-performance-…

In a word, I am hoping someone can systematically address the concerns I have raised through a rigorous scientific treatment - showing studies with alternative results and a narrative tying those results together to explain how PE got this big. I, for one, cannot see a narrative that explains PE's modern-day zeitgeist.

Private Equity Interview Course

  • 2,447 questions - 203 PE funds. Crowdsourced from 750k+ members
  • 9 Detailed LBO Modeling Tests and 15+ hours of video solutions.
  • Trusted by over 1,000 aspiring private equity professionals just like you.

Comments (161)

  • VP in VC
Jun 9, 2020 - 11:36am

I think this is an interesting topic. I work in the industry so I am extremely biased. As soon as I read your post I got defensive and thought of the below:

  • MOIC vs. IRR: I'll just leave this here

  • Growth perpetuity: Nobody thinks companies growing quickly are going to continue that growth; generally people expect growth to slowdown

  • Particular pedigrees: Generally a pedigrees serve a purpose; MBAs have great connections to fill seats; consultants have good operating experience; DCM guys probably make good treasurers

What specifically are you reading about DE Shaw and 2S? You do realize LTCM was one of the greatest blow ups of all time, right?

I do wrestle with the idea that the industry is pretty stale all in all and I am looking for financial innovation. Who doesn't want to be in the present day version of private equity in the 80s?

Jun 9, 2020 - 12:11pm

had the same reaction, like the poster was speaking in absolutes almost and didn't think critically about what he was saying at all. No one uses IRR only or MOIC only, like that's legitimately something said if you have no idea what you're talking about. Flipping one cent in one second is not people are looking for at all! Deals happen like this in credit arbitrage / high yield players who try to go buy debt trading at 93c and sell it for 95 a month later. No scale, and small absolute returns. Anyway everyone knows this already I guess.

plus, he essentially pre qualified his statement to apply to (not necessarily shitty) shitty small companies with small compliance, legal, etc. and no formal processes etc. Yeah if you look at people who are running around at random trying to pull in more money anyone can pull numbers out of their ass. Like what's the point in making an assertion thats limited to something no one disagrees on e.g. people who are trying to sell sometimes misrepresent. Durr?

  • Associate 1 in PE - LBOs
Jun 9, 2020 - 12:05pm
  • Returns/MoM/IRR: In my experience, PE firms are well aware of the limitations of these metrics, and almost all DO use IRR, which is best compared to public market returns on a risk-adjusted basis (the most meaningful comparison in my view for most alternatives investors). They are used in the ways you describe because they still work as effective marketing tools. PE, like many other businesses, is sometimes in the public-facing PR/fundraising mode. There are external advisors to LPs who make more statistically meaningful comparisons that you describe. A PE firm's incentive on its own is to present the best version of the story (it is our / the LPs' jobs to be skeptical and push back).

  • I don't know any PE firm that puts blind faith in Porter's 5 Forces. We don't even use it - would be a bit silly and bookish. We have also almost never hired "pedigree" management teams - we always hire management teams that are either true industry insiders and/or we have worked with in the past so they are a known quantity (less risk).

Having said that, PE is a very human business. For an industry that does so much technology investing, it itself is almost entirely a human-centric services model. The models are basic and built in Excel. The humans choose which analyses to do on the company's data and present the exhibits they think are relevant. [Several of these analyses are more scientific than others - such as comparable growth-multiple regressions, attrition curves] Ultimately, many different people (the deal team, the IC) will look at the data and model, and make a non-scientific/human/qualitative judgment about the investment. There is no formula or aggregator algorithm that makes sense of all the various trends and metrics, and spits out an answer. The entire thing is more of an art than a science.

The industry can certainly do more - use more dynamic tools (Tableau, Power BI), use better/any deal management software, seek larger datasets (from the company and also from their commercial due diligence partners) etc.

But the performance of PE (vs. some hedge funds...) tells me that the status quo is not crazy. Private companies are a different animal and it is honestly just hard to imagine how you do something fundamentally more data-driven and scientific that the hedge funds sometimes do (but I am open to being proven wrong over the next 10 years). Perhaps, that is what good investing is - the human-centric art rather than stiff science.

Most Helpful
Jun 9, 2020 - 12:09pm

If you think Private Equity is bad at finance wait until you get a load of Growth Equity... or worse, VC!

I realize I'm in a dedicated fuh-nance forum, but I think it's helpful to decouple the concept of "Finance" and the concept of "Business." Finance is a subset of business, but there are other elements of the business "stack" that are important, like Management, Industry Expertise, Marketing, Product Development, Operations, etc. and every business is going to score differently on requirements for these different axes.

The Private Equity business relies heavily on finance, but it does not rely exclusively on finance - it sources from generally illiquid markets, takes much more operational involvement to get to a liquidity event, and just generally has to deal with a lot more humans - so there's just no universe in which it's an apples-to-apples comparison to a quant hedge fund.

Nobody is pretending that Private Equity is the most exalted form of finance but it also takes a bunch of other skills to be good at it, so generally people don't confuse this. By the same token, nobody is asking a liquid market investor why they don't provide better operational value-add to the companies they invest in, it's just not the same business.

“Millionaires don't use astrology, billionaires do”
  • 33
Jun 10, 2020 - 11:01am

Exactly. I wouldn't consider the primary function of being a PE GP, at the leadership level, finance. The job isn't to be a high-iq financial engineer - its to source and negotiate good deals, hire and advise the right management team, and develop relationships with relevant exit groups (strategic or public).

Your best PE/GE/VC leaders are high-IQ business leaders, and can pay for high-IQ financial services if that is required.

Learn More

300+ video lessons across 6 modeling courses taught by elite practitioners at the top investment banks and private equity funds -- Excel Modeling -- Financial Statement Modeling -- M&A Modeling -- LBO Modeling -- DCF and Valuation Modeling -- ALL INCLUDED + 2 Huge Bonuses.

Learn more
Jun 9, 2020 - 12:22pm

While I made some criticisms about seeming like you don't know what you mean to say or are really talking about (because no actual, well ran, large funds have these issues essentially) because most people on this site work in companies that are on the bigger side and have a long history and have developed formal processes. E.g. your concerns are self qualified to the point they're kind of irrelevant. Also Ive never seen anyone use porters, that's like a consultant thing. I mean yeah memos have upside downside etc but there's way more things that are different at each PE firm like a way to evaluate management for example.

I think PE can be low-IQ vs venture and other things maybe because being a genius doesn't help you that much in my opinion, there's so much process that it helps sure but idk how much (my iq ain't big enough fo dat). This is mainly geared at being a junior though cause that's what I am, analyst->VP/director even.

in my opinion PE investing is very process oriented and revolves bringing around industry experts and other people to do the hard work of realizing strategy. PE people understand process, potential, etc. and I honestly don't see too much room for a 'genius' to make an impact much more than a bookworm nerd who's good at doing his homework (if you understand what I'm getting at). this is for mostly junior levels. even when it comes to sourcing there's a standardized DD process and putting to an IC meeting means a standardized memo and a basic investment thesis that's not dissimilar to what college kids can do (interns can do this stuff).

With venture it seems like there's more capacity because you try to navigate more ambiguity, which increases risk/reward profile. PE does it's best for companies that are good but could realize scale synergies or in fragmented industries. They make good companies better and taking risks on companies that are bad is just not worth it. Read about Thoma bravo and what he did and he basically just pivoted to what I'm saying in the PE space especially in software everyone is trying to do what he is doing and it's not very risky because the underlying business is actually great.

I don't think you need to be a genius in PE because it's process oriented. there's room for critical thinking and analysis but unfortunately there's so many ways to filter out potential prospects and after that cut through ambiguity with a knife because of past deals and experience as well as having a good process.

I typed up some general and random comments that I don't know are clear but yeah wanted to write my thoughts.

Jun 11, 2020 - 3:29pm

Porter's 5 forces is not even a consulting thing... Can anybody find me a consultant that has ever taken a decision based on that framework? At most I left it as an appendix because some dumb client somehow wanted to see it, but you know they pay our fees so happy to chuck in a useless slide if asked to.

Jun 9, 2020 - 1:19pm

I agree in a sense here but my suggestion is to not put statistics on a pedestal. I mean, one of the examples you gave of sophistication was also one of the biggest frauds in financial history.

However, this is an interesting problem. Sophisticated statistics cannot be applied to private equity both due to their short histories and higher volatility (compared to mutual funds) as a group. But could there be a 'best' statistical method to judge and allocate money to private equity funds? I, for one, can't wait for some Nobel prize winner to come up with a sophisticated mathematical method of evaluating PE funds, start a massive fund, and then go bust in 3 years.

Jun 11, 2020 - 3:55pm

right, it's very hard to do it with PE companies because they're constantly changing- past results won't be able to predict future ones very well at all. Tons of variance into why things went well or poor.

Also, the actual investing strategies of PE won't change or how value is created. Just how FoF operate and LP's decide to allocate capital. But again, it won't affect people who game the system / are obviously amazing-- they have more demand for funds than they ever can use.

Jun 9, 2020 - 1:26pm

It's interesting that posting an opinion berating PE elicits comments suggesting I don't know what I am talking about without offering scientific evidence to refute some of the points I was raising. Think this kind of shows what I mean - and again I only decided to post this in order to offer a bit of variety to what otherwise seems like a monologue around PE on Wall Street Oasis.

If the only metric by which you judge LTCM is that they blew-up (which I am very aware of), then I think you've sadly missed the point and novelty in what they were doing and the implications it had for finance and investing more generally.

Here is some scientific work to back-up the concerns I raised. I could be wrong, but would love to have scientifically informed views rather than the same old trite mish-mash sold to PE associates.

  1. MOIC vs IRR - the oaktree document is fallacious in my mind - it offers a misuse of IRR (e.g. not using time of fund-start as time of IRR calculation, annualizing returns exagerates returns for short-term investments (no duh) etc.) as the example and then takes it down. If PE is misusing IRR as a measuring stick, then the answer is just that - not that MOIC is better because PE is misusing IRR.

  2. Pedigree - https://verdadcap.com/archive/do-mbas-make-better-ceos , https://verdadcap.com/archive/is-ceo-performance-persistent

  • Conclusion: "Our findings suggest that the "best and brightest" do not appear to have a statistically significant edge when it comes to managing public companies. An elite pedigree-the type of pedigree favored by head hunters and corporate boards-is not predictive of superior management. One of the central rationales for Michael Jensen's campaign (increasing CEO pay by tying it to share price performance) appears, in retrospect, to have little empirical support. These credentials, however, are significantly overrepresented in the CEO biography database. The elite credentials thus benefit the individual, but there is little evidence that these credentials benefit shareholders."
  1. Persistence - https://www.calpers.ca.gov/docs/board-agendas/201511/invest/Workshop02-…, https://pdfs.semanticscholar.org/3c31/135608cf8cbcfbad3c236073729b61827…
  • Conclusion: "Post-2000 we find little evidence for persistence in buyout funds, except for the lower-end of the performance distribution"
  1. Performance Measurement - https://www.aqr.com/Insights/Research/White-Papers/Demystifying-Illiqui…, https://www.aqr.com/Insights/Perspectives/The-Illiquidity-Discount
  • Conclusion: "Our analysis suggests that private equity does not seem to offer as attractive a net-of-fee return edge over public market counterparts as it did 15–20 years ago, from either a historical or forward-looking perspective. Institutional interest in private equity has increased despite its mediocre performance in the past decade versus corresponding public markets, and weak evidence on the existence of an illiquidity premium. Although this demand may reflect a (possibly misplaced) conviction in the illiquidity premium, it may also be due to the appeal of the smoothed returns of illiquid assets in general."

I would keep going but have to jump now. Will respond to other points later today.

Jun 9, 2020 - 2:16pm

Making a list of things people are doing wrong is easy and almost useless. Allocators already have an army of analysts that are more than aware of pretty much anything someone could put to a journal so if allocators decide to invest it is always despite those shortcomings. And they do it for one reason: despite the lack of good data and optimized metrics, there is an insane amount of money to be made in private equity. Not only that but allocators are individuals or institutions who already have insane amounts of money. They don't particularly care about the risk-adjusted returns in the way a smaller investor would. I'd say they care mostly about making sure they get a big enough piece of the PE pie and they are more than willing to find a smart person with a strategy that makes sense and who can be trusted.

Will a more scientific approach eventually be discovered? I'm sure it will. Will allocators wait until that research is out before giving out their money? Not at all. So PE funds will be there to fill that demand.

Jun 9, 2020 - 9:32pm

people use both moic (and in a true committee moic * check size aka $ value creation) as well as irr. Because unlike intro to finance there's search costs, info asymmetry, deal fees and a bunch of other uncertainties so blindly maximizing irr doesn't make sense. What's better deal team that sources one great deal 25% irr and that's it with 500m cap gain ? Or 20% and 3bn cap gain? The first team left alpha on the table. Ability to deploy matters a ton. Illiquid markets involve sourcing deals I think you are too blindly comparing to liquid markets and assuming every footnote of the capm is true

Fyi to be clear even irr doesn't matter only npv. Point being team 2 generated more npv

Funniest
Jun 10, 2020 - 11:10am

I feel like the OP just finished up a finance class at Booth (purely academic approach not real world) and their eyes are open to the "truth" of PE. It's kinda like some kids in undergrad who finish Psych 101 and are now some expert on how the human mind works.

Jun 9, 2020 - 8:15pm

love the principle of trying to bring something new to the discussion actually and appreciate it. however using your own personal anecdotes to remark on something industry wide is not scientific principle at all. How are you extrapolating this problem (it doesn't really exist which is why people are questioning what you're saying).

but don't you see how you've self qualified to the point it's kind of weird or doesn't make sense to even think about for most of the original post?

additionally, the standard of determination is kind of irrelevant in the sense that people just use the most 'seemingly correct' way and 'sell' off of that. The actual investing process for PE companies can use purely IRR when they pre qualify investments of a particular size. IRR and MOIC should be used in conjunction to balance each other's limitation of scale and timing respectively.

In extending your line of thinking say ways of measuring alpha are OK but not the 'best' to possibly exist. We will simply evolve and change and those who a) like everything else learn the 'system' or game it the best or b) who are standout above and beyond amazing (e.g. obviously top decile returns, etc), will be successful however these successful people will be so regardless of anything really. They're not the ones who have problems raising funds. like, they're already oversubscribed and demand exceeds hard caps by like hella %.

while you may be pointing out an absence of something with IRR, MOIC, or any metric, any limitation is only important in the nitty gritty. Why? Because some funds, firms, strategies are standout great and you wish you could invest with them. They have more people trying to invest with them and give money than their strategies scale to. Agree/disagree? Your problem being posed isn't too relevant for top performers in any metric because they don't need or is there any real purpose to better metrics. thoughts? maybe for bottom 75% fighting for investment it matters but rarely does innovation chase middling performers.

Jun 9, 2020 - 8:48pm

It sounds like you're trying to over-fit a narrative to construct a controversial post title.

I could construct an argument against quant HF. RennTech product isn't scalable. They've had to return all outside capital in their actual alpha monster fund. I could also say is quant HF the low-IQ hair loss medical research? The clinical science in hair loss research is leaps and bounds above RennTech. RennTech's statistical models have no consistent efficacy and in fact completely break down over time. Wouldn't make it into a single peer review journal.

Further, RennTech offers no societal or economic benefit other than to the 150 rocket scientists who work there. Therefore over time the mobs will come for RennTech, but not hair loss research. The fundamental goal of any organism is self-preservation, unless the mental faculties are so limited that they cannot even preserve their existence. So RennTech IQ

Array
  • 5
  • 2
Jun 10, 2020 - 1:42am

RennTech's Medallion fund, which has returned about 70% annually since 1988, still manages $10B, even if none of that is outside capital. Pretty crazy to say that isn't scalable. The rest of the argument concerning hair-loss doesn't make any sense to me.

Array
  • 1
  • 1
Jun 10, 2020 - 1:10pm

rentech medallion fund does short term quant trading and has highly levered positions typically.

the point is that these things are just way too different. the reason rentech, sig, Jane Street, whoever can make money on short term quant trading is because they have strong algo on sentiments and short term trading which has a limited upside in scale. they add ZERO value to society (other than making markets more efficient in ABSTRACT, by taking money from everyday individuals referring to last sentences by above comments) How much money is in this market? why don't they take outside money and replicate the strategy at a bigger scale (they can't or they would). legit the only company doing it this well doesn't mean you should say 'see look what these guys are doing, everyone else is doing it wrong'. how about everyone is doing different things that aren't comparable, some strategies might be better (like medallion fund) but some VC companies have posted 100x returns. Why not compare those two? it doesn't make sense to use anecdotes and nitpicking companies

the point is that those tstrategies have literally nothing to do with rentech other funds which don't do nearly as well (because they're LT), institutional HF L/S investing, or private equity where there's an active process to improving the company.

they're literally incomparable to even within rentech other funds lmao itself. it doesn't even make sense what the original poster guy is trying to conflate and 'fit' as a narrative. so many wrong assumptions all over the place. that's what this guy means (I think)

Jun 11, 2020 - 12:24am

RennTech chooses to only manage internal capital because it's so damn high returning. I know one LP (a family office here in Asia) that was grandfathered in by virtue of being an early investor. They rave about RennTech and said that the family office's problem is that the best quant funds can't be bothered to run external money. Why take in external funds at 2/20, and pay out 80% of the winnings when you can generate 60% returns on your own money? Why go thru the capital management headaches when you can just watch your owm money stack up? Plus yes, there are scalability issues to certain trading strategies.

There's a local quant fund here in HK that's generating also about 60% annualized. They figure the market size for their strategy is only about $100mn. Above that there's no market. They flat out refuse to take outside money.

Jun 9, 2020 - 9:02pm

The only important metric is how much the founders of the firm are making and how sustainable what they're doing is. If you look at things that way, then I'd say PE is anything but a low IQ approach.

  • 1
Jun 10, 2020 - 12:33am

And even if your performance is good...if everyone else is dressing them up then you have to do the same.

Jun 10, 2020 - 1:41am

Take this perspective with a grain of salt from someone that has never worked a day in PE, but has some experience with public markets and quant trading/hedge funds. I don't really think of PE as a low IQ approach to finance, but a low IQ approach to investing, maybe... Of course, that isn't to say that it's easy (at all). To me, it seems like PE is a much more relationship driven business than public markets investing (duh). There is of course a certain level of analysis that needs to be done, but not to the same extent whatsoever. In private markets, investors can gain an edge by having access to information that others don't have, or by having access to certain relationships -- for example, if a a real estate developer is looking to sell a hot, high profile office building in NYC, there are only so many people/REPE firms that can even get into the room. In public markets on the other hand, people generally all have access to the same information, and it's the analysis of that information that makes the difference. I'm sure this will get MS but to me, public markets are the pinnacle of investing. It's a jungle baby

Array
  • 6
  • 2
Jun 10, 2020 - 2:22am

Depending on your strategy and maybe more applicable to LMM...you need the ability to grow a company. Not particularly easy.

Jun 10, 2020 - 3:43am

I'll grant you that public equity investing is difficult, and that developing an edge is difficult. But last I checked PE was pretty rigorous in analysis as well. 100+ slide decks, lots of modeling, and we're taking on liquidity risk. Yes, certainly relationships are a key driver, as they govern access to deals. But I don't think we skimp on analytics at all.

Jun 10, 2020 - 11:47am

100+ slide decks aren't illustrative of high-IQ.... just means PE firms are doggedly process driven. Why not have the 24 and 25 year olds whom we've fed BS about investing crack out decks that the partners will casually flip through?

Taking on illiquidity risk without an apparent illiquidity premium (look at the AQR article I posted), sounds like smart shit to me.

Jun 10, 2020 - 2:16pm

I posted this elsewhere but will post it here as well.

I think glorifying 100+ slide decks as advanced analytics is driven by some form of stockholm syndrome and simulateneuously illustrates a lack of recognition of an underlying problem in processing that information.

I would argue that the larger the number of slides, the harder it becomes to cognitively process all the relevant data... ultimately reaching a point of impossibility and irrelevance that can easily backfire.

Here are a few papers that comment on information overload/processing and persistent errors in judgement.

  1. "What do we notice and how does this affect what we learn and come to believe? I present a model of an agent who learns to make forecasts on the basis of readily available information, but is selective as to which information he attends: he chooses whether to attend as a function of current beliefs about whether such information is predictive. If the agent does not attend to some piece of information, it cannot be recalled at a later date. He uses Bayes' rule to update his beliefs given attended-to information, but does not attempt to fill in missing information. The model demonstrates how selective attention may lead the agent to persistently fail to recognize important empirical regularities, make biased forecasts, and hold incorrect beliefs about the statistical relationship between variables. In addition, it identifies factors that make such errors more likely or persistent. "

Source: http://www.dartmouth.edu/~jschwartzstein/papers/sa.pdf

  1. "We show, for example, that a person may never realize her self-control problem even when it leads to damaging behavior, and may never notice the correlation in others' advice even when that failure leads her to follow repetitive advice too much. More generally, we show that for every error there exists an environment where the error persists and is costly. Uncertainty about the optimal action paves the way for incidental learning, while being dogmatic creates a barrier."

Source: https://www.hbs.edu/faculty/Publication%20Files/18-108_14ac3bb3-cd23-4eb2-944f-cdf579719cf2.pdf

Jun 10, 2020 - 6:03am

I disagree. Worked both sides, in both ST and IB, and I can certainly say that the DD process and analysis that goes into most PE investment is more complex and rigorous than what you could ever do on a public company, without getting jailed for insider trading. PE-analysts and associates know their companies way better than most equity research analysts/investors know their public companies, just because they can ask for, and are provided with, way more information.

I don't know... Yeah. Almost definitely yes.

  • 6
Jun 10, 2020 - 2:45pm
QuiltEmerson:

I disagree. Worked both sides, in both ST and IB, and I can certainly say that the DD process and analysis that goes into most PE investment is more complex and rigorous than what you could ever do on a public company, without getting jailed for insider trading. PE-analysts and associates know their companies way better than most equity research analysts/investors know their public companies, just because they can ask for, and are provided with, way more information.

Agree, most intense due diligence of any investment type.

Jun 11, 2020 - 4:04pm

That's overly simplistic in my opinion- the nature of where information comes and if it's led through an auction process by a banker or sourced originally (aka bankers bid prices up through competitive auction, sourced originally helps reduce price paid very easy to boost returns like that) is just an amplifier of returns. It's not the end all be all and in many cases complicates how to look at things by 10x than the standardized way you can pull from so much industry research on public companies (defined market, analyst reports, ripping from a 10-k). It's much harder and granular with PE sometimes which increases ambiguity way more than public investing. That's why in my opinion the funds worth investing publicly are those guys who only make a few positions a year but spend months learning about the company. I think that's why PE associates go to Tiger Cubs and be successful- really, truly, getting to granular analysis down to brass tacks. Your comment is similar to me saying it's easy for public investing because you can find their info on a 10k. It's kind of true and false but not very related to actual investing, strategy, principle, or anything like that. Just a little thing that can help or hurt, and at the end of the day there's a whole spectrum of investors who do things so differently. You're point may or may not be true, may or may not be attributable to a generality, but if so works for everything not just PE tbh. It's a drop in the hat (from a pure thinking perspective it's just awkward your comments-- but you're not wrong necessarily).

Jun 10, 2020 - 10:43am

MOIC used with a number of other metrics can tell you something and is not completely useless.

HOWEVER, let's not pretend that there aren't PE guys out there who are relying on MOIC a little too much as well as other simplistic metrics.

Sadly, I can't tell you how many times I've heard someone say, "I don't like the deal because forward EBITDA is 7.0x and that's expensive" or "I don't like the deal because MOIC isn't exactly 2.5x."

MOIC when used with other metrics isn't stupid. Unfortunately, a lot of people using MOIC are stupid....

Jun 10, 2020 - 11:49am

Exactly.... this is what I am talking about. The truth is there are a number of guys who actually think MOIC is a barometer, hence the "if I can double my money from this business, that would be a nice deal"

Jun 10, 2020 - 1:27pm

but they're not the ones who succeed and do well. these aren't the people with top decile returns. anyone's who works at a good shop will just be like "ok, what's your point... duh, these people exist but by and large that's actually not remotely anything we do."

you're literally self qualifying to people who suck. the same thing would be someone in public markets investing saying "don't want to invest because their PE ratio is 12 blah blah blah"

also, people like to filter quantitatively because it reduces the potential investment pool (quant screens, hello?) some have the luxury of enough opportunities to only go forward and doing real diligence on things with certain metrics. You are self qualifying to the 9th realm, using poor logic to justify base characteristics of comparison which is wrong (you haven't tested those assumptions with anyone in reality, you're just proposing your conclusions without testing your assumptions), and intermingling insane anecdotes, assumptions, etc.

it sounds like you're the bad investor for assuming these things- where is your due diligence? you sound like one of those consultants who takes a piece of info and runs with it to eternity making conclusion after conclusion. sometimes it doesn't match up to reality- when you run into someone who can see thru the BS they're not 'defensive' 'ignorant' etc. maybe you're just saying something stupid and committing the same acts of 'low IQ' that you believe others have (which ZERO people in this thread have disagreed on- what's the point of saying shitty people are shitty and good strategies are good?). You are on a different planet trying to create some logical basis around this dude

Jun 10, 2020 - 4:59pm

What could have been an interesting thread has devolved into insults and petty name-calling but since there has been talk of performance metrics going on, I'll say this:

No PE fund investor in the world ever looks at MOIC and makes a decision on whether to invest in a fund or not. Ditto for IRR. Ditto for DPI. Ditto for RVPI. Ditto for TVPI. You take all of those together at multiple funds and evaluate them. But you don't stop there either. You take the Fund's track record and then run PME analysis to check for out-performance over public markets. You check this both on a IRR and Dollar value added basis. Theres a lot more to slicing and dicing a fund and firm's track record. And guess what, the firms that have received funding are able to show that they add value on all of those metrics or they will simply find it impoossible to raise capital.

It's laughable to say that a PE Partner only considers MOIC or only considers IRR when looking at an investment.

Jun 10, 2020 - 8:39pm

Not sure how that comment is relevant given what I was talking about. You can use monte carlo simulations instead of point estimates in DCF models to simulate a greater range of outcomes (talking about revenue, COGS, WACC, Interest rates, etc.). Company specific stuff you can bootstrap a distribution from company history.

Jun 10, 2020 - 9:02pm

The comment is relevant insofar as you have pointed to MOICs being a particularly unscientific approach in paragraph 2 of your post.

Other people have tried to explain to you what you are missing here but you immediately dismiss them of having Stockholm Syndrome (what?).

When you start talking about monte carlo simulations and other more 'scientific approaches' to PE, you are thinking like a junior Analyst rather a Partner at a PE who has real wealth tied to the deals he or she does. I see this in WSO with folks who ask why VBA is not extensievely used in IB, or why Python is not used in PE.

You see - these 'scientific tools' are not used because ultimately PE (at the Partner level) is substantially more art than science. The future is unknownable yet PE investors have to project a company's operating performance and the corresponding macro environment before deciding to make an investment. This ultimately comes down to a 'sense of the deal', which quite frankly, means the gut instinct of the senior folks on the IC. Deeper / more sophisticated analysis doesnt really mean much in that context. And that's correct - that's how it should be, that's why the senior folks earn the big bucks. This is not an industry where you can input a bunch of stuff into a black box computer program that can then spit out a 'YES/NO' decision, irrespective of how scientific or complex the process is. Money is made in this industry for human pattern recognition, for selecting, managing, retaining and incentivizing management teams (show me a scientific program that can do that), for judgement in managing a bid and exit process, for figuring out how to create value within a business so that it can grow at GDP+. None of the above requires anything more than Class 10 math, an above average IQ and a relatievely high EQ.

So in that sense yes, PE is a low IQ version of finance in the same way that Picasso is a low IQ version of a human being.

Do I have Stockholm Syndrome?

Jun 11, 2020 - 1:00am

That's a weird clip to quote since Hoss wins the debate (

)..

I am genuinely curious, hence why I started this thread.

I just did some back of the envelope math today and think that most if not all of the MFs historical returns are not statistically significantly different from zero. And certainly not statistically significantly different from the industry average.

Industry Average = ~13%
MF PE Returns = ~15-25%
Std. Dev of Returns = ~100%
Sample Size of Platform deals = ~ 100

Jun 11, 2020 - 1:26am

Well I'm not sure industry average means much to me personally. My former PE shop generated 144% IRR, realized. When I was in real estate PE, my fund generated 84% IRR. But I suppose that was really Asia's heyday. Now returns are more around 24%. Maybe some under-performers are dragging returns down, or maybe it's different in other geographies. As in most industries pareto principle applies. The vast majority of returns go to the top half-decile of players. That's specifically because it's an inefficient market. Above you mentioned one form of inefficiency - relationships/access, but you may also want to factor in methodology for value-creation, branding which attracts the best deals, and just plain old-fashioned analytics. Quoting a broad industry statistic (on an N=100) makes for an interesting academic talking point, but little more than that. I think if you checked HFs, you'd find the industry largely underperforms indicies if one subtracts fees. This is the problem with statistics - they are not necessarily telling the whole story.

Jun 11, 2020 - 9:28am
Achilles88:

That's a weird clip to quote since Hoss wins the debate

I will hand it to you, this was actually a great comeback, haha. Very Taylor Mason-esque actually.

“Millionaires don't use astrology, billionaires do”
  • 1
Jun 11, 2020 - 1:44am

I am making my career decisions based on what I see as empirical truth and untruth. It's a folly to sell top decile returns as anything more than statistical artificats if they indeed are. Look at how David Harding approaches this at minute 4:30-5:00 (

).

If you are betting on pre-identifying good funds to join, then take a look at David Swensen over at Yale. He has been unable to meaningfully outperform the Cambridge Associates average PE return for the past 20 years. For reference, Yale's 20 year historical return on its leveraged buyout investments is 12.1% ( https://static1.squarespace.com/static/55db7b87e4b0dca22fba2438/t/5c8b0… ), while the 20-year PE industry average return, during the same period, according to Cambridge Associates is ~12.32% (this could be survivorship bias, but still quite embarassing if you ask me).

If Swensen cannot outperform the PE index despite probably having access to "top decile managers", then why do you believe you can pick a PE firm that will generate gargantuan returns without it being a statistical artifact?

Jun 11, 2020 - 11:47am

If you're looking to identify a priori a broadly-defined asset class that will perform better than PE has over the last 30 years to make a career decision, you are exceedingly unlikely to do so, even if you are right about PE.

I would suggest trying to identify a career in which you believe you, yourself, have a distinct advantage...and I concede to you that, for professionals in PE, many have become exceedingly successful without having been plus "PE Investors"

Jun 11, 2020 - 9:57am

I think that's pretty smart actually. You read the statistics that almost no one ever consistently beats the market. Well, maybe not a good idea to become a hedge fund analyst then.

My question is why do so many people learn these stats in business school and then delude themselves into thinking that they're gonna be the 1% that consistently beats the market and are God's gift to trading??? Seems kind of weird to me.

I've seen some of the smartest people I know get blown up in hedge fund after hedge fund by the whims of the market. I'm really glad that I looked at the broad industry statistics and did not choose that career path.

Jun 11, 2020 - 2:00am

It seems you're looking for something but I don't know what. You seem to want someone to either validate your choice to go into quant funds, or to defend PE as an asset class. I'm not sure anyone really feels like doing that - at least I don't. I recognize that PE has a place in an institutional investor's bucket, especially if you can get into the top firms. I also believe in a basket portfolio approach. I also value quant funds, and pray one day RennTech or my friend's closed quant fund here in HK will accept my capital. For me this is not a binary choice.

Re Yale - I'm going step a bit out of my depth here, but I believe there's multiple factors in portfolio composition, including duration, correlation, degrees of principle protection, liquidity, beta, etc. Yale's endowment has been the top or one of the top performing endowments precisely because of their access to top decile funds, and their outsized allocation to private markets (to venture by the way, moreso than PE). An endowment like Yale's is putting together a mixed basket of assets. So I'm intrigued - seems you don't like the basket of assets, the so-called "endowment model". So what do you propose instead? You're spending time in analysis, what do you think is a better asset mix, and please show your methodology and calcs. Genuinely curious.

It's also interesting to hear you quote CA's stats in particular. I remember meeting w/ CA annually circa 2007-2009. You know what the best performing asset class over a 10 / 15 year was on the books at the time? VC. Why? Because VC absolutely killed it in 1996-2001. Until the party stopped, and from 2001 to 2009 VC was a disaster, with annualized returns of 6%. Why do I share this? To illustrate the mistake of relying on datasets without taking into account that certain asset classes perform really well in certain conditions and at certain times and not in others. That is why endowments take a basket approach to portfolio allocation.

But I'm happy to learn something new. I am genuinely interested in your methodology and thought process, which I hope you can detail. So you want us to believe what exactly? That quant funds are all super-high-performing and we should all go 100% into quant funds? That PE is a shitshow no one should touch? That endowments like Yale are cocking it up and David Swenson needs to be taken out behind the woodshed and shot? I'm really not getting your overall point.

Jun 11, 2020 - 2:44am

I am faced with an intellectual dilemma and trying to resolve it. For me, it revolves around intellectual honesty above anything. I can't help but think a lot of PE is trite mish-mash with the industry growth stemming from statistical artifacts, leveraged beta, errors in institutional investor beliefs about persistence, high expected returns, diversification benefits, etc. (things that don't actually exist). In my mind, leveraged buyouts, at their heart, are no different from stock-picking ( I get the extra diligence points raised, etc.). But at its heart, it is levered stock picking with massive illiquidity and no creative hedging options. I call it illiquid, long-only, levered, stock-picking (ILL Stock-Picking, for short). Right now, I am seeing fundamental L/S equity investors get hammered time and again for lack of alpha generation. Yet, somehow ILL Stock-picking a la Blackstone and Apollo is the holy grail of alpha?

I compare this with alternative methods of investing/finance (stat arb, momentum, HFT.. even high-sample size areas like mortgages or commodities) and can't help but think that those forms of investing are more intellectually honest and not as riddled with empirical errors. Simulataneaously I notice that Blackstone is over twice as large by AUM as the next biggest quant fund and scratch my head. I understand that quant strategies may be harder to scale, but it seems like a labor market breakdown to funnel top talent and money to investment programs with questionable alpha generation.

In a word, I am hoping someone can systematically address the concerns I have raised through a rigorous scientific treatment - showing studies with alternative results and a narrative tying those results together to explain how PE got this big. I, for one, cannot see a narrative that explains PE's modern-day zeitgeist.

Jun 11, 2020 - 5:17am

This is simple corporate finance like Corp fin 101. In fact take this q to your professor. Two projects one required 10,000 units of labor and you can invest 1bn into it, it'll return 12% and wacc is 12%. Project two requires 100 units of labor and invest 100m into hot, it lol return 25% nd wacc is 12%.

You're looking at the above scenario and shaking your head: what's your point? That project two (aka quant funds) should have 10k units of labor? Well that investment oppty doesn't exist or quant funds would be scaled massively. It's an extremely attractive oppty that's close to tapped out. If you can get a job, great you'll make bank. But unless alpha is being destroyed (note fees offsetting alpha is rational - and that's the long term market equilibrium), pe should not shrink.

Basic Corp fin

Jun 11, 2020 - 11:41am

The idea of "persistent returns" recurs in your responses - has there been an asset class (broadly defined) that generated returns that persist alongside the AUM growth that PE has experienced more successfully? You seem to gloss over it, but it is important - the quant strategies where the % returns persist by and large have capped AUM in order to facilitate that.

It's quite basic...what does 25% return look like compounded over 20 years? 30? When bearing in mind that we live within the finite parameters of the world economy, it's quite intuitive that returns don't "persist"

For the record I think continued returns compression in PE is quite likely, and there is no need to overcomplicate it - any biz once reaching a natural saturation point (wherever that may fall) will see it's returns decrease. There are frontiers beyond which no business can expand for self-evident reasons.

PE has been an extraordinarily successful mode of investing that may well have run its course - actually it is hard to imagine why anyone would feel strongly that either of those isn't the case.

Jun 11, 2020 - 12:25pm

Yes, that is something I have wrestles with. And it seems that persistence of returns goes hand in hand with strategy complexity. Here is an interesting study:

"An asset that consistently provides a compelling risk-adjusted return would seemingly attract a new crowd of investors, the increased demand quickly driving down returns.

Yet that's not always the case. More complex assets, such as mortgage-backed securities, which persistently generate outsized risk-adjusted returns when run through effective arbitrage strategies, tend not to be overrun by the capitalistic herd mentality.

The most complex strategies deliver alpha and higher risk-adjusted returns - as measured by the Sharpe ratio. But the level of expertise needed to extract the value dampens its popularity. In their model, less complex strategies have a Sharpe ratio of 0.50 and a 61 percent participation rate (among a class of sophisticated investors, not the general population). The most complex strategies deliver more than double that Sharpe ratio, but the number of participants is nearly halved. The researchers liken the dynamic to the "industrial organizational model" that gives more efficient (read: low-cost) expert manufacturers a competitive moat that can push out less efficient competitors.

'Thus, our theory explains why complex assets can have permanent alpha,' the researchers conclude.

...

To capture the potential excess return of a complex asset while simultaneously taming risk requires a big-time investment in intellectual and operational capital. The more complex a strategy, the more Ph.D.-toting quants are needed to grind out sophisticated models with the support of a crack trading desk armed with state-of-the-art software and hardware that can deftly execute the strategy. That's not exactly easy or cheap to build and maintain."

Source: https://www.anderson.ucla.edu/faculty-and-research/anderson-review/comp…

Jun 15, 2020 - 1:50pm

Thanks, I found your response/citation interesting, but it begets the following questions:

  • Is your impression that LBO funds are competing for LP allocation vs. MBS strategies?
  • "Risk-adjusted" can substantially weaken expected returns - does the "complex" MBS strategy attain comparable absolute returns vs. LBO funds?
  • Against what is the "alpha" measured for these complex strategies (incl. the FI ones)? What plagues PE's "alpha" generation is that Public Equities (esp. in U.S.) have had a ludicrous run of capital appreciation, against which any alternative asset class would struggle to compete while attracting any meaningful amount of AUM

Actually, the underlying NBER paper that sits behind your citation does not mention private equity nor LBO's - I think the thesis aligns more closely with my original post than your thesis about PE. Nevertheless, an interesting exploration

Jun 12, 2020 - 12:18am

Thank IBB.
I would love to hear your thoughts on the stats being quote. For me, the reality of HF and PE fund returns don't tie up with OP's points. I was in a BB's cap intro before, serving HFs. I had barely any HF clients returning higher than mid-teens. The exceptions were the highly volatile funds that returned 50%+ one year, and -10% the next. We called them 'rollercoasters.' The PE funds that I knew and worked in had generally consistent returns of 25%+ IRRs and in some cases far more than that. But one would have to have patience as those investments worked their way through their process. Illiquidity challenges were many.

So when I think to OP's point on comparing industry average in PE with the top performing quant funds, I have several thoughts in terms of problems in his analysis from a statistical standpoing. Would love your insights.

  • not comparing like-for-like: OP is comparing PE industry average returns against the top tier cherry-picked hedge funds. If he's going to be comparing RennTech to a PE average that is illogical. He should compare it to top performing PE funds, and not likely even mega funds like Blackstone, but to funds like Sequoia, Vista and Thoma Bravo. Here in Asia I know of several funds that exceeded 70% and in some cases 100% IRRs. Now repeatabiltiy can be debated, but these funds certainly knocked the cover off the ball, making comparions to industry average irrelevant.

  • survivorship bias - HFs and quant funds in particular which underperform are shut down. PE funds take 10 years to wind down. This is going to skew any comparison of industry returns beteween the two. When I was in cap intro HF shutdowns and launches were a weekly occurrance. Tough to compare.

  • volatility and repeatability - Paulson killed it in the GFC. Then the funds wasn't so great thereafter. Not every fund can be as consistent as RennTech or Thomas Howard's Athena funds. The degree to which one can access a consistent and top-performing fund in either PE or quant is key. Few funds in either camp have strong performance and repeatability, but if you can find one, jump in and don't look back. Be grateful for the access. But that's really more of a business operations problem (ie. how does one run a good PE/VC/HF) rather than an asset class selection problem. Put in other words, 'winners win' and it pays to be with a winner.

  • perverse incentives - many quant funds have been accused of picking up pennies in front of a steamroller because of the risks they take, and the consequences of their models failing. Because HFs are paid on the up returns, but with little consequence from down losses (other than the firm shutting down and the personnel moving) there is continued incentive for HFs to utilize short-term thinking, and take outsized risks which they share with LPs while allowing the LPs to bear the brunt of failures in their strategy.

There's a reason large LPs take a mixed approach between asset classes so that there's a mix of low-correlation risks and liquidities. I think if one is big enough, that's the right way to go about it.

Thoughts?

Jun 12, 2020 - 3:05am

To clarify, I purposefully haven't referred to RenTech on this thread - again I mentioned multiple different quant strategies (HFT, mortgages, commodities, momentum, futures trend-following, stat arb).

Academic literature would seem to suggest that persistence of returns goes hand in hand with strategy complexity, which seems convincing to me. Think of it in the most simple terms, investing is a competitive market just like any other economic market. The "easier" it is to invest, the harder it is to generate profit consistently (i.e. alpha). Things that define easiness of investing are barriers to entry - like firm size (e.g. AUM, traders, research desk, etc.), size of capital pool, technical complexity of the asset class/strategy, broker channels, etc. PE strikes me as a fairly uncomplex asset class, meaning the barriers to entry are relatively low (IB/Corp Dev experience plus AUM). The strategies I am referring to often require PhD-level technical skills plus AUM, which is a much smaller percentage of the investing population. Here is an interesting study:

"An asset that consistently provides a compelling risk-adjusted return would seemingly attract a new crowd of investors, the increased demand quickly driving down returns.

Yet that's not always the case. More complex assets, such as mortgage-backed securities, which persistently generate outsized risk-adjusted returns when run through effective arbitrage strategies, tend not to be overrun by the capitalistic herd mentality.

The most complex strategies deliver alpha and higher risk-adjusted returns - as measured by the Sharpe ratio. But the level of expertise needed to extract the value dampens its popularity. In their model, less complex strategies have a Sharpe ratio of 0.50 and a 61 percent participation rate (among a class of sophisticated investors, not the general population). The most complex strategies deliver more than double that Sharpe ratio, but the number of participants is nearly halved. The researchers liken the dynamic to the "industrial organizational model" that gives more efficient (read: low-cost) expert manufacturers a competitive moat that can push out less efficient competitors.

To capture the potential excess return of a complex asset while simultaneously taming risk requires a big-time investment in intellectual and operational capital. The more complex a strategy, the more Ph.D.-toting quants are needed to grind out sophisticated models with the support of a crack trading desk armed with state-of-the-art software and hardware that can deftly execute the strategy. That's not exactly easy or cheap to build and maintain.

'Thus, our theory explains why complex assets can have permanent alpha,' the researchers conclude."

Source: https://www.anderson.ucla.edu/faculty-and-research/anderson-review/comp…

Jun 12, 2020 - 3:11am

To clarify, I purposefully haven't referred to RenTech on this thread. Again I mentioned multiple different quant strategies (HFT, mortgages, commodities, momentum, futures trend-following, stat arb).

Academic literature would seem to suggest that persistence of returns goes hand in hand with strategy complexity, which seems convincing to me. Think of it in the most simple terms, investing is a competitive market just like any other economic market. The "easier" it is to invest, the harder it is to generate profit consistently (i.e. alpha). Things that define easiness of investing are barriers to entry - like firm size (e.g. AUM, traders, research desk, etc.), size of capital pool, technical complexity of the asset class/strategy, broker channels, etc. PE strikes me as a fairly uncomplex asset class, meaning the barriers to entry are relatively low (IB/Corp Dev experience plus AUM). The strategies I am referring to often require PhD-level technical skills plus AUM, which is a much smaller percentage of the investing population. Here is an interesting study:

"An asset that consistently provides a compelling risk-adjusted return would seemingly attract a new crowd of investors, the increased demand quickly driving down returns.

Yet that's not always the case. More complex assets, such as mortgage-backed securities, which persistently generate outsized risk-adjusted returns when run through effective arbitrage strategies, tend not to be overrun by the capitalistic herd mentality.

The most complex strategies deliver alpha and higher risk-adjusted returns - as measured by the Sharpe ratio. But the level of expertise needed to extract the value dampens its popularity. In their model, less complex strategies have a Sharpe ratio of 0.50 and a 61 percent participation rate (among a class of sophisticated investors, not the general population). The most complex strategies deliver more than double that Sharpe ratio, but the number of participants is nearly halved. The researchers liken the dynamic to the "industrial organizational model" that gives more efficient (read: low-cost) expert manufacturers a competitive moat that can push out less efficient competitors.

To capture the potential excess return of a complex asset while simultaneously taming risk requires a big-time investment in intellectual and operational capital. The more complex a strategy, the more Ph.D.-toting quants are needed to grind out sophisticated models with the support of a crack trading desk armed with state-of-the-art software and hardware that can deftly execute the strategy. That's not exactly easy or cheap to build and maintain.

'Thus, our theory explains why complex assets can have permanent alpha,' the researchers conclude."

Source: https://www.anderson.ucla.edu/faculty-and-research/anderson-review/comp…

Jun 11, 2020 - 1:45pm
Achilles88:

the only relevant metric should be IRR),

The minute I saw this line, it was all I needed to see. The real world of owning, managing, and investing in businesses is way more complex than the assumptions that drive IRR (at least in a ex ante world, ex post... who cares). It really should not be compared to other investing strategies, let alone those involving publicly traded debt and equities. That is the 'funny money' world, most of the world's assets are 'privately held'. It's upside down view to not realize that assets are not always made to be traded.

I realize most PE firms don't do lifetime holds, but really the assets and businesses are too complex to think that forecasting can work to manage the future.

But than again, I come from the RE world, we know you can't eat IRR and those who live by it are 'small time'.

Jun 12, 2020 - 1:20pm

PE at the end of the day is investing and hence requires skills to identify good companies and make investment selectively. And not everyone can be a good investor, even after IB training and mastering an LBO model.

I wonder if many of the PE people are actually interested in investing, or did they just get in the industry just because it's a thing to do after IB? I remember my associate talking about public stocks just like any other retail investors.

Jun 13, 2020 - 5:20am

Quoting Fama for this argument is ill-advised. Fama is a staunch believer in the efficient markets hypothesis. He's an evangelist for it even though he has been proven wrong conclusively and repeatedly. Of course he would say that private equity cannot outperform the market.

There are four things that I would encourage you to keep in mind. 1) Private equity returns at top funds persist. Top decile firms are great places to park money, and they absolutely generate alpha. 2) Debt enforces discipline on otherwise bad management. This is the reason that Apollo and KKR rose to prominence. 3) Private firms can make decisions that cannot be made at public firms. A great example of this was Michael Dell + Silver Lake. Dell would be dead in the water if it weren't for that take-private. 4) Publicly traded firms can often find themselves at a disadvantage. Capital raises, reporting requirements, and activism are a giant pain in the ass. This is why the universe of public securities is shrinking.

Yes, there was a private equity bubble, but it became a bubble for a reason.

Jun 13, 2020 - 6:00am

I feel like you stopped reading my post after the first point.

I wouldn't call Fama a staunch supporter of the Efficient Markets Hypothesis; I would say he is the one who formulated it as an overarching framework - hence the 2013 Nobel Prize. So, yes, I am aware that he believes in efficient markets and still chose to purposefully quote him for this... because his argument is spot-on.

Do you have any empirical evidence that there is persistence of returns to the partnership for top decile funds? The literature I've seen and is quoted under point #3 of my original post shows that there is none. The most rational expectation of returns for a firm whose previous fund was a top decile fund is the industry average, not a repeat of the top decile performance.

The latter points you're making - debt enforces discipline (originally a Michael Jensen paper) and control premium (a la Michael Dell) - are very trite and unconvincing in my opinion. But by all means, if you have empirical evidence showing proof for those points, please share.

Jun 13, 2020 - 8:15pm

Fama is a zealot whose greatest contribution to finance stopped working within 10 years of publishing. You can disprove his entire philosophy with 30 seconds of thought. He knew the CAPM didn't work, so he P-hacked two "factors" to replace the CAPM and claimed that those factors worked because the markets were rewarding risk-taking, they were behaving efficiently. Two things happened. 1) His factors didn't persist so his original hypothesis was wrong. 2) He was promptly ignored by the entire corporate finance community. If he was right then the CAPM should have changed. Either the markets don't behave efficiently, or he was wrong.

I don't spend my time reading academic journals, but I can tell you from experience that leveraging a company absolutely results in changed behavior, and there is value in control.

If you want to dig more into PE return persistence then I would invite you to go look at any report on the topic from Cambridge Associates. That isn't a controversial statement. Top performing funds have persistent returns.

Jun 15, 2020 - 3:26pm

Didnt read your entire post since its lengthy, but yes PE is quite dumb. (See, I work in the industry and didnt even take time to read your entire post).

Basically, if your buying a company for 7-8x EBITDA, and put on 3-4x of debt. Your IRR will be sick just by keeping it flat and deleveraging the business. Lots of PE guys like to use fancy words like "improve operational efficiencies", "expand margins", "perform strategic add-on acquisitions that benefit form synergies", but this is all bullshit.

Some of the OG PE chads bought 30-50M EBITDA businesses at like 5-6x back in the 80s and 90s, pretty hrad to not make insane returns when buying a business of that scale at such a low multiple.

Ppl might disagree with me but PE is just about buying businsses at low multiples, using a bunch of leverage and pretending to be smart.

Jun 15, 2020 - 8:27pm

yeah I mean you hit the fundamentals. however, next time you type it up please obfuscate with jargon-- thanks.

but you kind of structured what you said a bit awkwardly / conflating 2 ideas:

1) principle use of leverage to get returns: get OK returns but pretty good
2) multiple expansion: on it's own, hell yeah. combined with leverage, praise the lawd.

and then there's 3, which you touched on:
ebitda margin expansion or outright growth (from topline growth) which everyone "tries" to do because you get paid big money for this one! this is where most of the money is paid "for", yet it is arguably not even necessary enough times. Investing strategies should be more clear.

I think benchmarking increased margin expansion or from increased revenue should have a baseline and then that's what PE investors should be compensated for. The other 2 things aren't something that should be compensated for because they are more from structuring the transaction. Upside shouldn't include the first two for sure! Until these three are unlinked from another then there will be a lack of true incentive in this space

Jun 16, 2020 - 2:59pm

Aperiam eligendi velit dolores est ipsa est nulla qui. Earum voluptas soluta id in illum ut tenetur eos. Alias repellat rem fugiat qui. Id illum dolores temporibus voluptas aspernatur et. Provident sunt rerum dicta voluptatem eius.

Recusandae quidem facilis at. Deserunt nisi nesciunt nemo qui fugiat.

Voluptatem sed suscipit eos deserunt. Aut consequatur praesentium ipsum illo. Et dolor facere ut at ratione.

Voluptatem dolores qui consequuntur sit qui odio magnam. Magnam neque distinctio laborum officia voluptatibus pariatur. Fugit veritatis velit officiis et vitae et optio expedita. Rerum cum veniam repellendus veniam officia aut qui.

Array
Jul 4, 2020 - 5:48pm

Nulla quos minus rem animi. Est nam laborum harum. Quo quisquam doloremque velit numquam hic vero.

Repellendus atque minus repellat voluptatem. Iusto veritatis exercitationem pariatur rerum rerum ut minima sunt. Qui ex unde provident doloribus accusamus et dolorem. Animi nam atque qui ab vel architecto. Molestias aut non voluptatem necessitatibus sint eius.

Harum impedit et omnis aut et et. Et omnis illo atque autem cupiditate sint in. Beatae nihil alias velit. Voluptas et nisi eos et id ut.

Will update my computer soon and leave Incognito so I will disappear forever. How did I achieve Neanderthal by trolling? Some people are after me so need to close account for safety.
Jul 5, 2020 - 1:28am

Sequi sed sed pariatur. Quia hic in ipsa qui facere beatae impedit. Perferendis quasi et reprehenderit eligendi.

Dolor doloribus maiores dignissimos corrupti repudiandae ipsa non. Temporibus voluptas atque est voluptas deleniti sunt nostrum. Qui voluptatibus laboriosam reprehenderit voluptas aut velit unde delectus. Necessitatibus aut ea quod provident aut.

Aug 4, 2020 - 5:14pm

Et quos cumque vero modi laudantium aliquid dolorem. Aliquid ullam recusandae corporis dolore amet.

Velit dicta repellat ea optio eum. Aliquid numquam officiis aut deserunt. Rerum quaerat minima minima eligendi. Dicta natus a quis sed qui odio incidunt distinctio. Corporis ut voluptatem neque alias. Provident eligendi unde iste ex iusto sunt tempore.

Eveniet reprehenderit blanditiis dolorem tenetur saepe voluptatum facere. Omnis aut expedita nisi excepturi nulla. Rerum voluptas est sapiente est temporibus cum quam.

Repellat quidem provident numquam sunt atque ut molestiae qui. Sunt et ea quos dignissimos. Nobis natus consequatur id eligendi vel.

Start Discussion

Total Avg Compensation

September 2021 Private Equity

  • Principal (7) $694
  • Director/MD (18) $575
  • Vice President (67) $365
  • 3rd+ Year Associate (68) $270
  • 2nd Year Associate (139) $254
  • 1st Year Associate (284) $222
  • 3rd+ Year Analyst (25) $160
  • 2nd Year Analyst (61) $135
  • 1st Year Analyst (184) $118
  • Intern/Summer Associate (20) $67
  • Intern/Summer Analyst (219) $59