Jeffrey C. Hooke: "The Myth of Private Equity" | Talks at Google
It's. Obviously a pleasure to be here I'm gonna start off by taking, the poll how. Many people, have, heard. The fairy tale Jack, and the Beanstalk. Okay. Most of you well, as you recall from that fairy tale Jack was asked by his mother to take the cow family, cow to the market, and sell. It instead. He was waylaid along the way to the market by someone who offered. To exchange magic. Beans, for. The cow and those. Magic beans were supposed to translated, to great wealth for Jack and his mother so. In that particular case as you recall from the fairy tale the. Magic beans did return well he had to steal, gold from the Giant way up above but, it did did, result in wealth for Jack and his, mom but, when we talk about private, equity they have the same system they're promising. Sort. Of a magic, elixir or magic, beans for. Investors, that they're going to beat the market stock, markets dramatically, and as we're gonna learn today it. Simply, isn't the case and that's why the subject, of this talk is called a myth of private. Equity so. I like to start off a talk by telling you exactly what we're gonna go over so we've got six topics today we've got my background. What. Is private, equity is. It, a savior, for institutional, investors that want to beat the stock market, we'll talk a little bit as Pranay indicated, about private, equity returns, and the associated, fees and then. We'll close, with how, do big, institutions. Select. A private. Equity fund and then I'll take some questions, so. My, background, is a little unusual, I've. Had a number of different positions so, I was, an investment banker in New York for 15, years, I was an institutional, lender both in New York and at. The World Bank in. Washington. DC I've, done private, equity, in the emerging markets for a very large private equity fund as well as for the World Bank's private equity operation, as he. Put it out I was an author I'm also. Been. An expert witness in front of judges. Regarding. Financial matters, and as he pointed out I'm currently a professor of finance so I've had you know quite a number of different positions. Deal wise I've done mint deals all over the world so I've done US and 10 deals in Asia Latin, America Europe I mean, there probably isn't a deal that I haven't seen M&A, IPOs. Large, debt offerings, projects, and ants I've been I've kind of seen it all in my career and. That's. Led. Me to look at things in you, know various ways because I've been, exposed to so many different transactions. As well as different cultures how people, in various, countries and various institutions look, at transactions. And corporate finance so. I've had kind of had it in tool you know sort of intellectual, bent, which you don't see with a lot of Wall. Street type people, and so. I've sort of kind of analyzed, things I don't think it's necessarily. Helping my career much but, it's been interesting and of course you've maybe heard the expression, the. Unn you, know unreflective, life, is not worth living so, i guess i've lived by that sort of motto. Some. Books he's. He pointed out Wall, street-type books, but, I've. Done some academic, work lately as a professor, and the professors, and, I've worked with we've done papers, on private equity state. Pension, funds and we. Just finished a paper that's been going to be published by a journal, on private, foundations, and their investment, techniques I do. A lot of pro bono work if. You don't know what pro bono means it means free. Latin. For free so. I've done work because. I have a quite of investment. Banking a finance background I've done work for citizens, groups and tax payer groups in these four areas tobacco.
Lawsuit Fees, which ran into the billions like fifteen or twenty years ago, casino. Legalization, in various states many of the legislators, wanted to give these casinos licenses. Out for free I thought, it was wrong I thought it was unamerican so I let a fight to try to get to see States to charge quote, fair market, value for these licenses, and we had some success in probably. Caused the, casino industry two or three billion in fees public. Utility, mergers where the utilities, aren't giving enough of their. Benefits of the merger to the ratepayers, and then, as I said I've also done not only academic, research but some testimony. On behalf of, state. Pension, funds and investor, employee, unions, to see that those things are run properly my. Pro bono work also extends, to see if a society and the big fan of the CFA Institute, and, so, when I do travel, sometimes on vacation, sometimes in business if I have enough advance notice, I'll, contact. The local CFA, Society, it's a global organization, so I've been in. Front of audiences in places like Moscow, and Thailand, so. It's been kind of interesting, there as well so I know some of you are in the investment, club here at Google, so. You. Know investment. Club often means I like to buy stocks and sell stocks so I'll talk a couple words, about stock, picking based on my experience. Tens. Of thousands, of people are involved in the picking of stocks and many are extremely. Well trained at the top business schools and a lot of experience, so, if you're picking stocks personally. You remember you got a lot of competition. To. Be, right and actually. To beat the market so, what. Even with all these smart people doing, it it's very tough to beat the market most, professionals. Can't do it and these. People are working 24/7. Trying to be at the market you just can't do it those. Of those those, that can consistently, beat the market, it's a very small percentage. If. You look at fund managers. Going. Up against the S&P 500 less, than 0.1%, have. Beaten it over the last ten. Years consistently. So. They. Have the rare. Combination. Of extreme ability and luck and if. You look at statistically, if, you're. Guessing buy. Or sell for ten years if that's a binary choice, the. Chances, of being right for ten years or one, in a thousand. So. It's tough tough. To beat the market I, think. It's a good hobby so I do it, even. Though I don't think my results are that terrific, I think it's a good hobby it's easy to measure your performance against, the market you know it's objective, I don't, like being a baseball hitter or something but. If you are someone like, the people in this room you know you probably have a job it's full-time you're not going to be able to really, research. Stocks effectively. Against the pro so I would say you know reserved part of your portfolio for. Fun stock picking. The. Index most of it. So. Let's, get to the topic of, today's.
Talk Which is private, equity. And. Why it's a myth I'll describe private, equity for a minute so, the, way a private, equity fund works is you. Have a number of large institutional, investors 10, or 15 sometimes 20 putting. In tens of millions sometimes hundreds, of millions of dollars, into. A fund, so it's a big pot of money and, the. Fund is run. By. Investment. Banker types like myself and. So. The, fund is buying companies. For, the most part and. It's. Going to have a portfolio of say five or ten companies and. Then. These. Companies, are then going to be sold after a certain holding, period, so. It's like a mutual fund except. The number of investments, is very small and you control each one so, the fund is actually in control and helps guide the companies. So. The interesting, thing I find about private, equity as opposed to say a mutual fund is that, the investors, have a much. Longer time horizon. So. If. You're, gonna buy companies and, then sell them first you have to find them so, finding, a deal in itself is a full-time job, believe. Me then. You have to negotiate and, close, the, transaction. That's. So if you've, got a fund of say a billion dollars that's gonna take three or four years to invest that billion dollars. Then. Over the next few years you're, trying as, a, PE. Fund, manager, to work with the management teams of these various, companies that you own you're trying to improve the companies much, like if you buy a piece of real estate you, may say well I'm gonna paint it I'm gonna put Edition on it and then, I'll flip it so, they're trying to do the same thing except in a corporate world where, they've got a few years to try to improve the earnings of the company improve, the sales and. Then. Get the company ready for sale, at. This company ready for, sale and liquidation, so, then they've got three or four years after the holding, period to sell the companies now. Most, of them are sold in IP in M&A, deals cuz, they're very few IPOs, in the United States there's only a few hundred every year where there's 15,000. M&A deals every year so. They're then they sell the sell. The companies at the end of the ten years and hopefully the. Investors have got a good profit. So. If you look at it in sort. Of the narrow stock-picking. Way. These. Managers, are picking, companies. Almost, like you might pick stocks in a portfolio, so, they're very concentrated, but. They're essentially, picking, stocks, except, they're buying the whole company, so, that's the prime-minister like the way they do. It now the this. Chart doesn't show up but there's three. Categories. That dominate, private equity the largest, one would be leveraged buyouts and I'll talk about that in a minute venture. Capital, and growth equity would be about 20%, but LBOs, would be over 60% of the money and. What's. That what's a leveraged buyout well. A leveraged, buyout fund. It's. Got a basic strategy here, which is you buy five, or ten low tech companies, they have to be non cyclical, and they have to be profitable, so. They can borrow a lot of money thanks like loaning, to firms. That make money and so, the idea is that the LBO. Will. Have a lot more debt, than a similar publicly, traded company, like. Those in the russell 2000, and. The, idea you know very, basically. Is that the more debt you put on a conservatively. Managed, low tech company. The. Lower. The cost of capital if the, market, goes up, the. Stock market, goes up as does the M&A market at, the same pace, the. Internal. Rate of return of the private. Equity portfolio will, be greater than a similar, portfolio. Of publicly traded stocks, because, it has more debt more debt, would mean higher. Rate of return to. The equity holder of course if the stock market Falls. The. Reverse happens so, you will have more. Losses compared. To the public, market if you've got a lot of leverage so. The. Private equity fund in theory, should have more volatility. It should go up and down, more than the stock market because of the greater debt but the. Returns will be enhanced either up or down now. Venture, capital, funds you know we're here in Silicon, Valley venture capital. Is a little different, but it's the same principle you buy five or ten venture capital, investments, they're usually, the private, equity fund or the VC fund is not. Controlling. The company they don't own a majority interest, they're. Buying companies, that are already in business for the most part so they're not working. Out of a garage or, something and not all the VC investments, are high tech so. Here the companies are a lot younger than. The buyout business, so. The. VC fund, you, know the VC Partners are providing not only cash, but, some guidance and advice so, it's a little different than the LBO, business, because I think there's more involvement.
With The management team, so, the fundamental, objective of, the private equity industry is. They'd. Like to beat the stock market, because. If, they're not beating the stock market, the investors, big institutions. Like Harvard or. Singapore. Sovereign. Wealth fund will say what do I need you for I can just buy public. Stocks so, the idea is to have a higher rate, of return with. Less risk that's the sales pitch. So. If if if you look at that sales pitch. It. Would put. The. Private. Equity business at, a, higher rate of return the sp500 with, lower risk. Now. Some of you may remember if, you ever took a finance course that that defies. All finance. Theory back from the 50s. Supposedly. If you're higher. Than this market, line, the. Market, will come in everybody will invest in this and therefore drive. The returns down to, what's on this securities, market line is called so, that's, the theory so it contradicts, the theory, a lot, of PE, investors. Are, saying not. Only do I want to have the S&P return, from, private, equity fund I want to beat it and that's, because you can't sell these funds you can't sell your port, part of a private equity fund like you can sell stocks and. You're, also not. Getting. Instant. Feedback on what the price of your private equity portfolio is, because, there's. Some uncertainty, about what a private company is worth. So. There's, a thousands. Of funds out there as. I said I used to work for one and. The. Idea, from the fund. Managers, perspective is I want to start fund one, getting. The fees from. The investors, and hopefully getting profits, and then, while this fund is four or five years old I'll start the next one cuz, I don't need a lot of extra management, to start a new fund so, I'll start this, fund next, get fees from that while I'm selling part of one and then, as sort as fun two starts getting invested, I'll go to fund three so I'm compounding. The, profits, and I'm got, economies, of scale with the management. Now. As I said. It'd. Be nice if investors. Could beat, the market with these funds but and, earlier. They were say, before. 2005. As you can see the funds that were started, before that were consistently. Beating, yes in p500. But. People then started. Plunging. Into. These funds, because, these funds got much bigger there, was more competition. For deals and so. As you might expect when, there's more competition for transactions. The cost of the M&A, goes up and the, returns as a result decline so over the last 12 years or so you. Know the returns have not been very good relative, to the S&P 500 and. If. You look this is buyout, funds if you look at venture capital, there's a similar, return pattern, where people were piling, into these funds and so the returns have not been so. Terrific. So. If you look at fees as one element. Of the whole private. Equity equation. They're pretty high. So. The fees. On, a index. Mutual fund that you might buy from Vanguard, fidelity, might be five basis, points a year there peanuts, almost. Nothing and in, fact you know there's been some news that fidelity starting, to offer funds for nothing, so. You would invest in it not pay anything. Private. Equity on the other hand is about 300. Basis points a year so the fees are sixty times is great, so. The, manager. Of the, private equity fund has got to beat the S&P by, 3% every year just to compensate. The investors, for the fee so that's pretty tough and so. If you look at it like this kind of graph I, mean you, know getting into, this. Part of. Performance. Is so hard you know just a small percentage, of people can do that with a with, the public markets, and as. A result, with the high fee drag you're not investing, the investors, money a hundred percent you perhaps you're only you know the private equity funds only investing 80 percent of the investors money so there's a lot of hurdles that the, PE funds got a conquer. To try to beat the stock mark and I'd. Looked at one. Fun. You know a lot of states a lot of universities, and a lot of big institutions, don't know what their carry fees are they don't ask so. They're, not billed for a carry fee. The. Fees are deducted, before the investors. See. Their returns the, only fee that is is. Disclosed, an, accounting, way as 1.8%, so, unless the state of the university, asks, they don't get the Decarie. Fee New Jersey is one of the few states that actually ask so I just put that up here on the slide shows. You the fees are about 3% of last. Year. Now. The interesting, thing about. Private. Equity funds is the performance, is. For. The positive, performance. Is really dominated. By the top quartile, which. Means the top 25% of funds do very well, the. Second, quartile is around the stock market, and the third and a fourth are. Below, so you got half the people. That. I don't have a very good batting, average and if, you look at venture capital, the you know the chart would be very kind of similar.
The. Thing about those performance, numbers, is that, a lot of the performance numbers are based on transactions. That haven't been sold yet in other words the P firm has bought the company hasn't. Sold it yet so. How are they measuring, their performance well, they have. The ability to, mark to market their own. Investments. Nobody's really double-checking, like the auditors the, investors, the limited partners do not check and, that's you know it's sort of an honor system that always surprised, me maybe I'm a little hard bitten and cynical, but you know it surprised me that trillions. Of dollars going, in and nobody's really checking it so. I like, in the whole process, to a third-grader, you, know grading their own homework which. A little. Strange for this, kind of business so. Here's. The evidence so if you look at buyout funds. You. Know this is these are like 10 years ago and this, is statistics, or reasonably. Recent you. Can see even like 2010. 2011, most. Of the returns that they're vouching, for haven't, happened yet in terms of cash. Now. These deals haven't been sold so. You got funds, that are seven, eight nine years old that haven't sold half the stuff they own yet so. Maybe. You, know I question, a little bit whether they're worth as much as as the managers, say they are. So. If. You want to get a little more into the weeds I mean are they really worth as much as they said you, know I did a study with one of my colleagues and we looked at, what. Were the mark-to-market experienced, in the crash now, you would expect a company. With more leverage, like. The portfolio, companies, of an of. A leveraged buyout fund to decline more than the stock market for the reasons I mentioned earlier, but, if you look at the the, way they reported, it the leveraged. Buyout industry. Said guess. What our results. Were. Better than the stock market despite our higher leverage, so. That again. It would strike me as being totally the opposite, of what finance theory would tell you. So. We call that. Return. Smoothing, as the expression, so. You have the flexibility, to. Put your own markings. On your portfolio, you're, obviously gonna, do it a little slightly in your favor if you're a rational person to make yourself look better before, of course as I said the sales pitch is not only do we have higher, returns. In the stock market, but we're also less volatile. Anyway. The sales pitch has made. Believers. Out of a lot of big institutions, so I looked. Again. With my cut one of my colleagues we looked at pension, fund returns, to the big states like California. New York Maryland we. Looked at their pension funds and you know they've made a, much. Larger. Dedication. To alternative. Assets, like private equity funds hedge fund. But. That. Stampede. Into private equity and all their alternatives, not really provided, a higher level return. So. If, you just compare your, average state pension, fund or endowment with, the a 60/40. Index, that you can buy it at you know from Vanguard or, fidelity. There's. A big difference the 60/40, outperforms. That by a significant. Margin now, people that aren't really acquainted, with Matt say well it's only 1%. What's. The big deal but. If you're running at a 50. Billion dollar pension and it's 1%. Every, year. That's 500 million a year you know, sooner or later you're talking some serious cash. So. How do these institutions. How do they pick the private equity funds they're trying to do their best they're trying to find, ones that are in, the top quartile how, do they do it so. There's two ways they do it one. Is they look at a fund that was in the top. Quartile. Previously. So. That fund is coming out with let's say fun. Number two so, the, investor, would say okay, they. Did well in fund number one I presume, they'll repeat the performance in fund. Number two, our, fund. Number three in this case so. What. Is the statistical probability, of. The. Third of the second fun beating the prior fund. It's. About 30%, so. It's almost random. So. That in Wall Street terms. That's called mean reversion. Now. You may be doing well for a while but then gradually, as time goes, on you can, you know you revert, to the average you're the same as everybody else, so.
With, LBO is about 30% so it's almost random, with, VC there seems to be more more, staying power like, a VC, firms are more adept at repeating their performance. Now. That's one option so, you try, to, go. To your top. Quartile funds and hope they repeat the performance unfortunately. Most of them don't so. What, about option. Number B that would be where you. Say I'm, just gonna be play it safe I'm gonna pick a big brand name fun so, I'll go with Goldman, or Carlyle, Group or, Kohlberg. Kravis they've, got you, know six or seven funds that history they're big names, I'll just invest in them, the. Problem, with that is that, if you look at the big fund families, like Carlyle, or Apollo or KKR, they, don't outperform. The. No-name funds so. Strategy. A or B doesn't seem to be a good, option I mean B, obviously, gives the, people. At the pension fund their endowment, some air cover, they. Can always say well it wasn't my fault at, the fund screwed up I went with Goldman Sachs they're. Supposed to know what they're doing. So. There's the old saying you can't get fired by, going with IBM it would be the same thing in the private. Equity business. Now. Portfolio. Patterns, how does it look with these funds, so. If you got 10 companies in a fund like. An average buyout you got about three that'll go bankrupt because of the high debt, you. Know sometimes it doesn't work out when you borrow a lot of money for, will be okay in terms of returns 3 will be as this thing goes home runs you, might be a 20 or 30% rate of return, these. C's are a little different you know they're it's more of a crapshoot you're dealing with younger companies a lot of times their technology, so. You know they're undeveloped. And either customer. Base and Technology are not known so, you know you've got a lot more bankruptcies. When. They do hit a premium, return it could be very high, you. Know just big, returns, I'm like say a boring low tech company, and the buyout, business. A. Couple, of case studies for those of you that are. Interested in venture, capital I'm, sure you've all heard of this one, darah knows I guess. Once you get on Forbes magazine, that's like the end of it you know I always. Used to think when some CEO, writes a book you. Know the stock is gonna tank because I've seen so many instances, where there's a book come out and then the stock of the company tanks, so, you know this, story is kind of well-known she, invented, the, what. People thought was an exclusive technology. To do blood tests, just picking. Your finger instead of getting in and you, know a needle in your arm and. People. Were buying the story put, in hundreds of millions of dollars from you know still very knowledgeable, Silicon, Valley investors, she. Got a lot of publicity most. Of it was pretty good the value of the company, when a private basis went all the way up to nine billion dollars, until the roof.
Caved In and the journal, started picking. Up rumors, that the technology, really wasn't what. She and others said it was and of. Course the company I guess just announced it was liquidating, a couple weeks ago so the investors in the equity we're totally wiped out. What. About a good one let's why talk about that let's talk about a good one there are many good ones yeah, Roku is a, real. Success story so it's about ten year old and ten, years old they invented, the first. Streaming. Box for Netflix, and then they developed some other products, and you, know went the normal sort, of process. That you'd like to see for, a high tech company of, raising, VC, and gradually getting a higher value, and then, going public at a big number and everybody. Got a terrific, rate of return now. Roku is still losing money despite, all this success so we're, just gonna have to wait and see you know in a few years if it turns out to be a real solid, business. Entity, that can commit can, sustain, its momentum, so. You might say. Why, do people, still invest. Why. Do big institutions. Invest in private equity haven't. They seen these statistics. Well. I'm. A little bit of a student of human nature and I've come up with a few. Sort. Of theories, about it having talked to many people so. I think you know one category, of investor, may be a true, optimist, you know that people always like to think they can do better than the stock markets they're saying I think I got a plan that we can do better and you. Know I think, private equity, is the way to go so these would be the true believers, and I, was doing some work on behalf the New Jersey employee unions, and, I. Looked. At the privates looking at the private equity portfolio, and the I remember, hearing the head, of the investment, committee. Talk and he's you know he's saying, mr.. Hook doesn't know anything you know we only invest in the top quartile private, equity funds so. I had looked at the top they invested, them 200 different funds and I looked at him and I.
Looked At their performance on a private, equity database, and. They. Weren't top quartile they weren't bottom but they weren't top if you took all hundred, together they, were exactly, in the middle so. They were doing say between the second and the third quartile which is what you'd expect if you selected the funds at random but, you had do have these people that simply believe that, now. The other, group, would be. Institutional. Investors, that listen, to their consultants, a lot so, every big pension fund most endowments, would have a consultant. That would tell them here's. The portfolio, allocation, you have you should allocate some of the stocks on the bonds and some to, alternatives. And so they're always pushing, alternatives, these consultants, and so. If you listen to them you're gonna be. An alternative, yourself, now a cynic might say why are they pushing alternatives. If they have, seen these statistics, well. If you are a consultant, you're getting paid millions of dollars a year. Well. Why would they continue paying if you just walked into the office and said I think. You should index, the whole portfolio well, then they say well what do we need you for the. C. Is the one I think, probably, the most applicable and it's unfortunate. But if. You're working at a big endowment, or if you're working a big state pension fund you're in the Investment, Office. You. Know you will have a job of picking managers. Usually so you're not investing the money yourself but you're picking managers, in stocks or bonds or hedge, funds or private equity, so. It's. Unlikely that, you are going to look at all the numbers and say well our strategy is wrong we've screwed, it up the last ten years because we're not beating a 60-40. Those. People's, jobs are dependent one. Having. A lot of different investments, to manage and supervise so. If they were to end walk into the Board, of Directors office. And say let's we, can't produce any premium, return, over an index so I therefore, hand in my resignation you. Know not many people are. Going to do that so. That would be called well you know, in finance, that's called an agency problem, where the investors, are using the managers.
As Agents, hoping to get a, good. Return and the last one is really this what I call the Stockholm, Syndrome. Now. The Stockholm, Syndrome is based on. People, like 20 or 30 years ago that were kidnapped by a gang in Stockholm. Sweden and, so. Over. Time as they were kept captive they, started sympathizing. With. Their kidnappers. Believing. What the kidnappers, told him and it was kind of a very interesting, psychological. Experiment. Or situation, so. If you talk to people in the business I, mean. Many of them go to conferences, and they're, all talking about how great private equity is or hedge fund and so. If you hang around people and they talk about this stuff you, started to believe it. So. That might be the fourth theory, but again as I said I think probably sea might be the overriding theory. Of, why. You. Know we still see a lot of. Private. Equity I like to tell my classes at the university, private, equity M&A is a, business, for optimists, so. You, have to think you're gonna do better than. The average and human. Nature tends, to be in many cases, optimistic, and the investment, business in a nutshell you know if you think you can get higher returns you you're gonna be an optimist, relative. To many others so. There's, a little bit of a circular. Facet. To this where you've got the claims of the PE funds, and, they basically. Can, as I, said mark-to-market their own businesses. Many, PE fees, are secret so people don't know what the. States are paying. Accounting. Doesn't require that the fees be disclosed, so, it's a self-perpetuating, circle. And. It's. Been very effective that's, why if, you believe in the efficient market theory you would say wait wait a second, time out you. Know there shouldn't be a private, equity industry as big as it is but. You know the markets not quite efficient, because the information simply, isn't out there for many, of the investors. So. On that note I will stop, and take a few questions. Anybody. Have a question. They'd like to ask. Thanks. Chef appreciate, the talk I was. Wondering if you have the same sort of view towards. Private. Equity equity. Funds that. Say. That they specialize, in a particular asset class like real. Estate versus, in for infrastructure. Funds or, versus. I guess. Well. Yeah I mean do you do you have any you. Know thoughts about those, types of funds, kind, of what how they compare, to. Funds. That are purchasing businesses. Like LBOs. Versus. You know we, invest, in roads or, whatever sure. Well. Infrastructure. Funds are kind of too new and, to. Be. Sort. Of analyzed in that way where you can look at a long term track record the. Other problem with infrastructure, funds is is that tends to be no public equivalent. That's easily. Definable. In the same way as a private, infrastructure, fund so, that would be a tough one real estate on the other hand as a long track record so. Private. Real estate funds would do roughly same as publicly traded REITs, real, estate investment, trusts that are publicly traded vehicles, that buy real estate and. If. You look I mean I haven't done a whole lot of study on this but if you look at, private. Real estate funds they also tend to be less volatile, than, publicly, traded REITs, which has raised some questions, about you know their mark-to-market, ability. Furniture. You got one here go ahead. Well. It's, clear you know these are these folks are running a business right I mean you know they're running a business to, obviously benefit, their, investors. But also they got to benefit themselves as, the owners of the business or the PE funds so the trend for the larger, ones is you know we've done about all we can in DC, we, can't grow much bigger in that market, because there. Just aren't enough good investment so it's not unusual that they say well there's some of the skills are very similar. To, private equity so, we'll take what we've learned in venture capital and transfer, it to growth equity or. Maybe. Not buyouts but growth equity and I agree with them I think there are a lot of similarities, deal closing, evaluation, accompanies, evaluation. And management and, markets so. It's a natural progression and, you've seen some of the bigger buyout, firms not only go into growth capital not, so much venture.
Capital, But you see them going into hedge funds, you see them going into lending, or they say well we've, done a lot of buyout, deals as an equity investor we can also do lending, so, it's just diversifying. Your business, make the. Patterns. Of earnings more stable, and predictable I. Was. Wondering if like you know any differences, in like say attitude, for, investing, in cultures. Like for example I can other countries like Asia versus, the United States I, got. Into Asia quite a bit I mean, from. The standpoint of REIT you know I think you got a distinguish, between quote, retail, investor. An institutional. So, if you go to retail. In, Asia I, think. They're much more. Interested. In speculation, you. Know here, you know I think investors, to even the retail you know they tend to be more analytically, inclined and they might, study the p/e ratio, of the company and how does it compare to others and what's, the growth record and all that sort of thing but I think the asian retail, investor. You. Know would be saying oh i heard it's a hot stock i'm gonna go buy it not do much analysis, so i think that would be the not that they don't do that here in the states and europe but i think they'd be a little more on the speculative, side. Institutionally. I haven't, noticed much difference, between say a big chinese, sovereign, wealth on and say a big university, i think they tend to travel. In the same circles, and they sort of do the similar investing, techniques. See. You later curt. Hi. Jeff thanks for the talk. Riffing. Off the previous question, if, you see that the retail investors, in certain countries or locations, tend. To be more of a musical or so have. You seen in your studies, a. Sort. Of like. Correlation. We, would say of PE. Being, successful, in some areas, versus, not or, some emerging, markets versus not are there are there like. These factors. Confounding. Factors that, basically. Make them any. Bit more successful, or not well. There are PE, and lots of emerging, markets now and. You know that's but it's a relatively new phenomenon, private. Equity and say. India or Malaysia or, or. You, know South, Africa, so I don't think there's enough data points really to measure it whether. They're PE funds, in emerging markets of beaten the ones I, shouldn't. Say whether they beat in the stock markets, in those countries I just don't think there's enough information there. Yeah. Um. Thank you for the lecture I. I. Couldn't. Help but note that if. You look you've presented a great slide which was the the history of performance. Relative to the SP or was it a 60/40. Wasn't quite clear which. And. It. Seemed fairly fairly, clear, that it was working. Relative. To the SP, for a good. While and then stopped do, you have any theories. About why. Yeah. Of course I do sir. I wouldn't. Be here if I didn't. Yeah. I mean I think. And. I like talked a bunch, of people in the business about it you know I think when.
There Was a lot of success, as this chart points out. People. Just investors. Just started buying, into these funds based. On their historical, track record, and so. As I said you know it's I sort of suggested. As people. Pile into these funds. The. Prices, for the targets, because there's only so many targets out there that. Fit the requirements, to be a buyout, candidate, for example so the price of the targets, therefore, went up so. As the price the targets, goes up the corresponding return, to the LBO investor drops a little doesn't go to zero but, it drops a little and so, the difference you can see is illustrated, by here, you know once people started, looking, at this track record they got you, know oh five, OH six oh seven where some of the biggest years for new funds so. There's a lot of competition for deals and I noticed that when I you know because I have a part-time at a investment, bank and I I see, the competition for transactions, where for an LBO candidate, we might get six seven offers so. You know who's the winner the one that offers the higher price where's. The winner then could be the loser because. You know they're paying too high a price so you got supply demand because, there's so much money. Trying. To find the same transaction, the, other aspect. Would be the fees you know the fees are just high, so. If you got a pretty high fee level that's just gonna be a drag on their return. Any. Other questions I. Got. Whatever you. In. The last few years. There's been a lot, of. Discussion. About the value. Go. That route and so, a lot of money is, flooding. That way now and do. You anticipate that there's any type of like, similar. Kind of effect that was actually having when you saw the returns on PE what's great a lot of money came that way and eventually than the returns aren't there is, is there any potential, like the same things happening on the index side now I'll be all just investing directly into the index funds I think. At some point if there's too much money going into index funds, then, there's going to be more opportunities, for stock, pickers people. That study and then pick individual, stocks because. So many. Passive. Funds will miss price you, know they're just buying stuff based on market cap but if, you look at the retail market. For mutual, funds it's about 30 percent indexed. And. Institutionally. You know the big. Big. Pools of money like pension. Funds or endowments, universities, I think it's the indexing, is only around 15, so. It's much, it's. Small so, when I've thought, about it and talked with people whose. Opinions. I respect I think the indexing. Part can probably go to 75, or 80 percent before.
Indexing. Returns, will then be beat, by. Those people that aren't indexing, but. You know so there's a long way to go a long way to go the other thing is that, perhaps. I should correct myself there, are a lot of people, managing. Money that could do what's called closet. Indexing, so, they're running a big, large. Cap fund for some money manager, or for some state pension, fund so, they're. Trying, to conform, their results, to the large-cap, index so. They are in effect even, though they claim they're picking stocks and doing all kinds of analysis they're trying, to stay close to what the, stocks are in the index so that they won't outperform. Or underperform, it by any meaningful amount so. That's you know a very conservative, strategy. You might say but I think, if you include, closet, indexing, my percentage is you maybe you double them for. What what's indexed, right now. Over. Here. Thank. You for the talk Jeff I have, a question so, do you think the competition. From the private equity actually. You know leaked. Oh you, know affect the public market, for example for. The reason years seems that the IPO. You. Know the surprised at, the way I view all the. The. Valuation. IPO, is it's pretty high and there's not much of a juice. Out of the IPO so. Part. Of yeah. So the question is is the private, equity market competing, with the public market, for, new listings, I'd. Say absolutely, so. You have a lot of companies, that you'd, think would be good IPO. Candidates, and. They're. Saying there's so much private, equity money out there why should I do an IPO because it's a pain in the neck to be a public company you've got everything at laid out there for everybody to read about you've. Got so many regulatory, matters, you have to address, everything. That you talk about on TV or in, press releases this can be microscope, by, a lawyer so. For. Many companies I do think it's a better idea to go private equity so there's so much private equity I think they're really retarding. The, number of IPOs and, I. Don't see that process. Slowing. Down I personally. Would like to see more IPO so the public investors have a shot at getting into a lot of growth companies, but, right. Now there's, just too much private, equity money available and I'm. Sure you see it here in Silicon, Valley a lot you know you see a good little company say well gee that's a good IPO candidate, but. You know it's just not happening the other factor, which you often don't hear mentioned, is that you. Know the investment banking, community is shrunk considerably, so.
Now You probably have you know five or ten firms that really dominate, the business and they. Would dominate IPOs, as well so. They. Tend to want to see bigger. Deals. They're, big companies it's economical. For them to do large IPOs so. With the demise of many smaller, banks. Who've got acquired or just you, know closed. You. Don't see as many smaller, D, there. Just aren't enough people to sell them so you've. Got those two factors, I think working against, the public market having more listings at least for now. Thank. You. General. Question, about. You. Know during. The Graham times there. Was a lot of focus on. Price-to-book. And then. The world moved on as the. Economy changed, and the nature of business has changed too looking at p/e ratios, and price to free cash flows. Do. You think there's a yet. Another paradigm, shift or this, is more where a good idea is taken to an extreme which. Of the two it is where you, have a. Very. Intangible, economy. Customers. Acquired now whose, values are realized over a long time and, p/e. Doesn't, reflect that economics. Well. You remember when Graham, and Dodd wrote that book we were just getting over a huge stock market, crash and so. The book was ultra conservative saying. You know focus. Heavily on the balance sheet just. That's, your backup, plan you know if you had a strong balance, sheet it's unlikely that the company could to go bankrupt so that was sort of their starting. Point look at the balance sheet then, let's look at the income statement, so now it's reversed you know people are looking much more at the income statement, and, I, guess, that's been pretty much the fashion. For the last 30 years and, that's sort of what my book was, sort, of an update at the Graham and Dodd. Authoritative. Book and. I don't think the paradigm has really changed, I think you know people today, are still focusing, on as you kind of pointed out a. Cash, flow. EBIT, da not. Looking at the balance sheet much unless it's a a financial, institution like, a bank, or an insurance company. What. I think is the noticeable last few years and this is sort of a repeat, of say, 99. 98, 2000. Is you. Know people are more willing to take a flyer on companies, that have you know a good sales progression. Without. Earnings. So. They've got good sales earning.
Are Going to come later and I, think now is, sort. Of a repeat it say 20 years ago and, I. Think. People have learned their lesson they're probably being a little more analytical, about than they were 20 years ago last internet boom but, I'm still a little cautious about it and. I'm still a little reluctant to. Advocate, buying the. Stock of companies that have you know huge losses even, though they are gathering customers, that you know could make a return in the future for the business. Yeah. Any. More. Unit, economic, basis, in, the last, combo. Probably. The companies, were not profitable, even, on a unit economics. Versus. Today one could argue the. Sure they're losing money but that's because the fixed costs right now is very high but on a unit economics they're still very profitable, and and. You know if they got a scale then you know those fixed costs may be covered obviously it's risky to know whether they'll gather. The scale or not you're. Actually no you're absolutely right I mean, if you once, you've got the fixed cost in place for a lot of these companies. Like uber or Twitter or somebody like that you know once you've got the fixed costs in place, as the, customer, count. Goes up and the revenues go up you know you're gonna get a lot of pure profit, dropping, to the bottom line but, I think as you and I talked about yesterday you know predicting which ones can. Actually pull that off is, a. Little tough. People. Have tried it in the past and you know most of them that pick 10, or 15 companies that are similar to ones you describe you. Know it's gonna be like venture capital 2 or 3 will be absolutely, fantastic returns. 4 or 5 will disappear, and then you. Know three or four will be okay I mean. I'm sorry that's the way the statistics work, I mean it frustrates, people you're, saying well I think I can pick winners I've got all this training or I know the internet business but yeah. It's, just very hard to consistently, do it. So. I had a question in. Today's. Low, interest rates. Jeff, how do you think about, what. Your discount rate should be imagine, of sea should be in valuing, equity, yeah. So a lot of. Predictions. On the future cash flow then have to be brought back, to the present if you're doing an analysis of a company so here. We've had seven, or eight years of very low interest rates by historical, standards you, know two or three percent for government bond is very, low compared, to history so. What. I do. Are. And what other you, know some other sort, of more conservative, investors, do is say well now we're in a period of unusually. Low rates so if I'm predicting, cash. Flow 15 years out or 10 years out to, use 2% or, 3% as. My base is just. Unrealistic, so. I, think. A more rational approach, is. What's. A normal, US. Treasury, bond rate for, the last 30, or 40 years it's probably around five or six percent so, I use that as as the, base rate for some kind of projection, and then, I add the risk on top so if you got your, base rate of five you. Add six or seven for investing, in the stock market, as this equity, risk that you're facing and then, you've got to add another one or two points, depending. On what industry you're in or whatever unique. Attributes, the company has so, for. A garden-variety, equity. Investment, I think you, know someone has to use a discount, rate of say 11 or 12 percent, to. Be fair, and objective. Thank, You pronounced push a thank you very much.