Is Tony Robbins Right About Private Equity?

In a recent CNBC interview Tony Robbins extolled the virtues of investing in private equity, arguing that private equity provided high returns – with low risk.  Is he right?  Should everyone invest in Private Equity?



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Links Mentioned:
The full CNBC video: https://www.youtube.com/watch?v=DWZ67Cx1zm8
An Inconvenient Fact: Private Equity Returns & The Billionaire Factory: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3623820
A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market: https://www.tandfonline.com/doi/pdf/10.2469/faj.v72.n4.1#:
Cliff Asness – Volatility Laundering: https://www.institutionalinvestor.com/article/2bstqfcskz9o72ospzlds/opinion/why-does-private-equity-get-to-play-make-believe-with-prices
Mark Anson Paper: https://www.jstor.org/stable/43503783
Aswath Damodaran Slides: https://pages.stern.nyu.edu/~adamodar/pdfiles/eqnotes/privateequity.pdf
MSCI Leverage in Private Equity: https://www.msci.com/www/blog-posts/leverage-in-private-equity-what/04942552461#:~:text=Leverage%20can%20be%20a%20key,improvements%20rather%20than%20financial%20engineering.

Transcript

A friend of mine sent me a link last week to a CNBC interview with the giant motivational speaker Tony Robbins where he extolled the virtues of investing in private equity. Robbins argued that private equity provided high returns – with low risk to rich investors – and that these great returns would soon become available to ordinary investors – and surprisingly – with no fees- in fact I was confused – as he seemed to be saying that you would receive fees as an investor.  All these rich idiots are paying fees – but somehow regular people won’t have to.  I haven’t watched CNBC in quite some time – but the whole thing came off as being like a commercial.

Now, I know very little about Tony Robbins, but – as you can probably guess – I was instantly skeptical – these claims fly in the face of all financial theory. To start with – it’s not obvious why investing in private companies would provide much higher returns than investing publicly listed companies – private companies are still just businesses – and are subject to the business cycle like all investments – and many of the private companies – were even taken private by investors paying a premium to the public shareholders.  It’s really not obvious why a privately held business would be less risky than a listed business – or that an investor should expect to get higher returns with lower risk.

Now I did some googeling – and I have to tell you I’m impressed by Tony Robins.  He has made some big promises in the past – and (at least in one case) appears to have lived up to them. More than 30 years ago Tony Robbins wrote a book called “Awaken the Giant Within” – and straight away I thought – well… who can do that.  The answer is Tony Robbins – he is 6 feet 7 inches tall – an actual giant.  There is no one better qualified to write a book like that. I’ll have to buy that one…

I realize that I probably shouldn’t have been so skeptical, anyone with a basic knowledge of history knows that giants – like Tony Robbins – probably have a goose that lays golden eggs – and so, maybe we should buy some of his magic beans. It has to work out.

So, first up, what is private equity – are the returns really as high as Tony Robbins says and is the risk as low. On top of that, when people say that private equity firms are evading taxes, destroying jobs and ruining the economy – are they right?

Well, private equity is quite simply investing in companies that are not listed on a stock exchange. Private equity funds can be broken down into venture capital – which involves investing in startups – which are high risk/high return; growth capital – which involves taking a minority stake in a mature company that either needs this capital to grow or needs it to commercialize a new product line, and finally, Leveraged Buyouts – where the fund uses a large amount of debt to purchase an entire company. In an LBO - the buyer usually uses the company's assets as collateral for the debt and plans to pay it off with the company's future cash flow. 

We’ll be focusing mostly on LBO’s today – as that is mostly what people mean by private equity, and there is a long history of transactions like this as people have been borrowing money to buy out businesses – as long as businesses have existed.  J. Pierpont Morgans acquisition of Carnegie Steel in 1901 for $480 million dollars is considered the first true major buyout, and the first leveraged buyout was the purchase of Pan Atlantic Steamship Company and Waterman Steamship by McClean Industries in 1955, where the buyer borrowed 42 million dollars for the transaction and were able to pay off 20 million dollars of that debt as soon as the transaction closed using the cash and assets of the acquired companies.

Up until the 1980’s the LBO remained an obscure financing technique – as since the great depression companies had had kept their debt loads low.  Robin Wigglesworth described in the FT how KKR’s 1978 purchase of Houdaille Industries using only one million dollars in equity for the $380 million dollar purchase was Private Equity’s genesis moment. The deal was structured such that the target firm itself was responsible for repaying the massive debt.

This deal showed just how ambitious even a small investment company could be and became a blueprint for the industry. Wigglesworth describes how the deal documents became widely read on Wall Street by people like Stephen Schwarzman, then a partner at Lehman Brothers.

Schwartzman wrote in his book (King of Capital) that he had read the deal prospectus, looked at the capital structure, and realized the returns that could be achieved. He described it as a Rosetta Stone for how to do leveraged buyouts. Over the next decade the LBO became the biggest business on Wall Street.

From the early 1960’s through until the late 1970’s American Executives participated in a wave of acquisitions where they built massive, diversified conglomerates. The ranks of middle management at these firms grew, and profitability began to decline as the businesses became too unwieldy to manage. Many of these businesses were trading at a discount to net asset value and the early LBO’s involved buying these businesses up on the cheap and breaking them up by selling off the pieces for something closer to fair value.  This break up approach led to a media backlash against the greed of these so called corporate raiders.  The character Gordon Gekko in the 1987 film Wall Street was based on a number of high-profile corporate raiders of the day – and was supposed to be the villain of the film. The writers were shocked when the public saw Gekko as a hero – rather than as a villain for his line "Greed is good”.

So how did these deals work?  Well, while every deal is unique, the one common element is financial leverage – or borrowed money – to complete the transaction. Some portion of the debt incurred in the LBO is secured by the assets of the acquired business, and its cashflows are used to service the buyout debt. With an LBO, the acquired company helps pay for itself – and for this reason the deals were sometimes called bootstrap acquisitions.

The high level of debt helps the private equity company to achieve acceptable returns for their investors and (maybe more importantly) provides tax savings due to the tax deductibility of interest expense.

Private equity companies often encourage top company management to invest alongside them in the deal. better aligning managements incentives with investors. It is argued that the large interest and principal expenses incurred, put management under pressure to improve operating efficiency and that the discipline of debt can force management to cut costs, divest non-core businesses and invest in technological upgrades to improve efficiency.

While private equity firms will be flexible in terms of what they invest in, the leveraged nature of their business means that strong cash flow generation and a strong asset base will matter a lot – as you can’t really borrow without these. Attractive valuations along with relatively little existing debt will matter too.

One of the key drivers of returns to early Leveraged Buyouts was that not only did expensing the interest payment on debt reduce the tax burden on the acquired company, but what was known as the General Utilities doctrine meant that a buyer who bought at least 80% of the stock of a corporation could treat the transaction for tax purposes as - liquidation of the corporation and purchase of its assets. Corporations liquidating their assets were not subject to capital gains tax on the appreciation in value on their assets, and what this meant was that the value of assets could be written up and re depreciated – reducing the taxes owed by the company.

These newly leveraged firms would have to pay little, if any, corporate income tax for the life of the buyout. This meant that no business turnaround was even needed - the same stream of corporate income now shielded from tax could be used to service the massive debt taken on in the transaction.

With the belief that the taxpayer was subsidizing leveraged buyouts, Ronald Regans Tax Reform act of 1986 repealed the General Utilities doctrine, reducing the profitability of these deals.

OK, so who Invests in Private Equity?  Tony Robbins told the CNBC audience that regular people don’t get a look in – it’s just the ultra-wealthy.  Well, when we look at the biggest investors in private equity, it is a mix of pension funds and sovereign wealth funds – which is basically the money of ordinary people. 

Just over half of the money in private equity comes from public pension funds, a quarter comes from sovereign wealth funds, then we’ve got insurance companies, foundations, private pension funds, banks and so on.  CPP, the Canadian pension plan is a huge allocator to private equity as is Calpers – the Californian public pension plan.  Broken down by country, The US ,Canada and Singapore are the biggest allocators. So when Tony asks – why do the richest people in the world get the greatest assets, it is maybe a bit misleading.  If you invest in private equity you are getting to invest like a teacher or a firefighter – not Jeff Bezos.  If you want to invest like Jeff Bezos – you’d have to put almost all of your money in Amazon – a publicly listed stock.

So, what do the investment returns look like then?  Tony said that the returns are 50 percent higher than public equities but that is not really accurate.  Firstly, private equity funds don’t actually report total returns like other fund managers do, they report the funds IRR – or internal rate of return. When an investor commits to invest in a private equity fund, their money doesn’t go in right away.  The first four to five years of a Private Equity Fund’s life are known as the investment period. In this period, the fund usually draws down committed capital to make investments into portfolio companies. Although they usually call in most of the committed capital during the first five years, it can sometimes take them longer to invest it all – such as if they feel there are no good investment opportunities.  Warren Buffett explained the problem with this at his shareholder meeting in 2019. Saying, “When you commit the money  [to private equity firms] they don’t take the money, but you pay a fee on the money that you’ve committed . . . you really have to have that money ready to come up with at any time. And of course, it makes their return look better, if you sit there for a long time in Treasury bills, which you have to hold, because they can call you up and demand the money, and they don’t count that [in their IRR calculations].”

There are other tricks too: The Wall Street Journal described in 2018 how the funds often don’t call the cash as soon as an investment is identified, instead borrowing money to make the investment – in what’s called a bridge loan, tapping investors’ for cash later.”

According to the Journal, this was originally done to make capital calls more predictable for investors. But while the practice doesn’t boost a fund’s cash profits, it does decreases the time during which investors’ cash is held in the fund delaying the moment when the clock starts ticking from an IRR calculation standpoint which can result in a significant boost in the IRR.

So as impressive as reported IRR’s often look – that is not the actual return that an investor gets. Internal rate of return is quite a problematic metric – it is a bit like yield to maturity on a bond where there is a built-in reinvestment assumption – which may not play out in real life, as the amount of capital invested changes over time.

It is not very easy to know average private equity returns, as the funds themselves don’t report returns to a central database, and the series of returns that people analyze contains survivorship bias.  When people claim that private equity outperforms public equities by three percent a year, a big problem with that number is that most of that outperformance happened twenty or more years ago when the industry was much smaller and there was more “low hanging fruit.” Over the last twenty years the outperformance has been closer to 1% a year- after fees, which while not as impressive is still good and should compound out into significantly greater wealth for investors over time. Sadly, using pitchbook data – it would appear that private equity stopped outperforming the S&P500 fifteen years ago – and over the last year significantly underperformed the stock market.

A 2014 paper from Oxford University made the argument that investors had been using the wrong benchmark – the MSCI All Country World Index - to judge private equity returns as that index has a weighting of about 50% for US stocks, and Private Equity funds invest about 80% of their money in the United States which has outperformed international stocks over that period.  Additionally Private Equity typically invests in smaller companies than are in the big US Indices and most importantly public equities use considerably less leverage than the companies in a Leveraged Buyout Fund.  The paper argued that you could not judge private equity returns without taking these factors into account. The author concluded that “if the benchmark is changed to small and value indices, and is levered up, the average buyout fund underperforms by 3.1% per annum” And that’s not what we are trying to do at all.  How are we going to awaken the giant within – if we are growing 3.1% less than our benchmark…

Building on this research – a paper in the financial analyst’s journal dug even deeper.  The authors used a more complete database of returns and conducted a thorough bottom-up analysis of the risk characteristics of the underlying companies in buyout funds. 

This paper found that the underlying companies that buy­out funds invest in have, on average, smaller market caps than their public counterparts. Their sector composition is materially different to big US indices (for example sig­nificantly overweight consumer discretionary stocks and underweight the Financials sec­tors), and their leverage is much higher than that of public companies in the same sector. When they adjusted for size, sector composition, and leverage of portfo­lio companies in buyout funds, the outperformance was reduced by more than half. Finally, when they adjusted for the vintage of the funds, they found no evidence of private equity out­performance.

That then leads us to Tony Robbins’ argument that private equity is low risk.  If the returns are the same as the returns of a levered investment in small cap stocks – because the funds make levered investments in small cap stocks – then an investment in private equity should be riskier than the average portfolio.  One risk that you are taking when investing in private equity is that your investment is illiquid – meaning you can’t necessarily get your money back quickly if you want it. Now normally when an investor takes an incremental risk like this, they expect to get an incremental return in compensation. It does not appear that with private equity, investors are being compensated for the illiquidity risk.

This leads us to Cliff Assness’s argument that private equity investors and fund managers are playing a dangerous game of what he calls “volatility laundering.”  Asness argues that the illiquidity of private equity and the fact that the assets are held at prices that in no way relate to real world asset values was historically acknowledged in the industry as a bug, but today, this bug - is being sold to investors as a feature. He points out that investors usually get paid to accept a bug – but are expected to pay up to receive a feature.

In market sell offs private equity funds are very slow to write down the value of their investments, but equally in market rises, they are slow to mark them up. Now, it shouldn’t be hard to adjust the value of a portfolio of private assets in line with the overall stock market – as if you’re levered long small cap equities and the stock market falls by 25 percent, your portfolio most likely fell by that amount or more. 

When people see the stock market fall – and private equity funds claim that their investments are just fine – they might get the feeling that they have a low-risk investment – but… best of luck selling it at anything close to the price it is marked to. What you have instead - is Schrodinger’s investment returns.

A 2002 paper by Mark Anson looked at the effect of stale pricing in the risk and return analysis of private equity investments.  Managers reporting unnecessarily stale pricing – as described by Cliff Asness can result in investors underestimating the risk of an investment and overestimating the managers’ skill.

Anson’s paper demonstrated that there was a significant lagged beta effect for leveraged buyouts, venture capital, and mezzanine debt investments and that the lagged market betas are statistically significant for up to four prior quarters of public stock market returns. Since betas are linearly additive, the sum of the lagged betas provides an estimate of the total systematic risk embedded within private equity portfolios. Anson found that the systematic risk in private equity was approximately double what it at first appeared to be.

Now, I’m not trying to beat up on Tony Robbins here – but it would appear that his assessment of investment risk is almost as skewed as his assessment of the risk of walking over hot coals – I’m basing that on a New York Times article which reported that thirty people had to be treated for burns after walking over hot coals at one of his seminars.  His website says, “walking over those hot coals is a symbolic experience that proves if you can make it through the fire, you can make it through anything.”  I guess that is an interesting way of working out which of your seminar attendees can’t make it through anything….  [clip crap cake]

The biggest problem in Tony’s statement on CNBC is that even if he was right that returns had been higher, and risk had been lower than public markets in the past – there is no reason to believe that an investor today will get the same returns.  When you invest in a strategy – you get its future returns – not its past returns.

If we followed Tony’s approach to investing, we would put everything in Altria Group – which used to be known as Philip Morris. It’s a tobacco company – and was the highest returning stock of the last 100 years.  A dollar invested a hundred years ago would be worth 2.65 million dollars today.

Most of the returns of investing in private equity came when the private equity business was a lot smaller than it is today – and under very different tax rules.  Today, we have dozens of massive buyout funds all chasing the same deals – meaning that they are significantly less likely to find underpriced assets than they found years ago.  The deal landscape today is nothing like what it was in 1978 when KKR put up a million dollars to buy a $380 million dollar company.  Today private equity firms are sitting on 2.6 trillion dollars of cash reserves looking for deals to do.

How did that 1978 deal work out anyhow?  Well – once levered up Houdaille had to manage more for cashflows than for profits – as they had those steep debt repayments to meet.  A severe recession came in 1981 – 1982 right as competition in making machine tools appeared from Japan.

Firm management petitioned the government for protection from Japanese imports but the request was denied. The company underwent a restructuring plan, spinning off a number of divisions to reduce debt. A year later it underwent another LBO or what might be more accurately called a recapitalization. The equity investors who paid $2.52 per share for their stock in 1979, received $11 per share seven years later. The recapitalization piled debt upon debt – at the high interest rates of the time - and the firm was eventually broken up and sold off in pieces.

One of the arguments in favor of investing in private equity is that that the number of public companies available to invest in today has reached a new low as startups have been staying private for much longer than in the past, and equity issuance net of stock buybacks is today at its lowest level in twenty-five years. It can be argued that these trends are working together to limit investment opportunities for public market investors.

Private equity can serve a valuable role in an institutional investor’s portfolio as it provides small-cap equity exposure which is worthwhile having, and the additional leverage might appeal to institutional investors with a long investment time horizon.  It is not obvious that retail investors should be stepping in when the research shows that they can get similar returns from a small cap equity index fund. Retail investors don’t need to deploy the same amount of capital as sovereign wealth funds and pension funds do.

The FT recently wrote that if the mosaic of assets managed by KKR were folded into one entity and listed on the stock market, its market cap would be comparable to industrial giants like GE, Lockheed Martin or 3M.  KKR now resembles the sprawling diversified conglomerates it once bought up.

According to Pitchbook data, Private Equities annualized Internal Rate of Return fell below 10 per cent in the year to March 2024, and over the same period an investment in the S&P 500 returned 30 per cent.  A big reason for this underperformance is that private equity is a levered investment in small cap stocks with sufficient cash flows to pay down their debts, while recent stock market performance has been driven by megacap tech firms – which private equity has no exposure to.

According to a presentation by Aswath Damodaran at NYU, private equity firms typically buy companies that have suffered declining profits in the two years leading up to the acquisition and profitability typically improves in the two years after acquisition.  This improvement he finds is most pronounced when leverage is higher.  The companies bought up have often underinvested relative to their peers before the acquisition, and there is a decline in investment after the acquisition.  Damodaran finds that private equity owned firms don’t default more frequently than similarly levered publicly listed firms.  He finds that while private equity is often blamed for job losses, there is little evidence to support this claim. Research shows that while layoffs often do come after an acquisition, new jobs are also frequently created in new businesses that these firms enter.

While people criticize private equity for exploiting the tax code – the tax shield associated with higher debt is available to every company – and if they are undertaxed – the blame lies with the politicians who write the tax code – not the companies governed by it.  If insufficient taxes are being collected – the government is able to change the tax code as they did in the 1980’s.

I don’t invest in private equity – and I don’t intend to either as I believe similar returns are available in public markets with better legal protections in place. I don’t worry about missing the boat on this front either – as right now it would appear that there might be too much money chasing too few deals – and I don’t expect to see huge returns out of these funds in the coming years.

I don’t have any objection to the industry either – I think that it is a net benefit to the economy to have people out there making changes at inefficiently run firms.  It strikes me that an economy made up of stagnant, badly managed companies wouldn’t provide more jobs or higher tax revenues – but feel free to disagree with me in the comments section.

Thanks for tuning in to this week’s podcast – with a special thanks to my supporters on Patreon – where I sometimes release the videos early. Talk to you again soon, bye.