Private equity is a $4 trillion industry based on a monumental misperception. Private-equity executives tout their ability to reap outsized returns by buying troubled companies, turning them around and selling them for multiple times their initial investment. But here’s a tip: You can do the same thing by buying highly leveraged small-cap stocks.
It’s not quite that simple – there are no simple ways to make money in the stock market – but private equity isn’t that complicated, either. Dan Rasmussen knows, because as a young Harvard graduate working at Bain Capital he was assigned to a team that analyzed what worked and what didn’t in private equity.
After examining 2,500 deals representing $350 billion in invested capital over 30 years – a data trove not easily available to investors outside the secretive PE business – Rasmussen, 29, came to several startling conclusions. First, private equity is mostly a levered small-cap strategy. Sure, there are headline-grabbing, multibillion-dollar acquisitions like TPG and KKR’s disastrous $48 billion takeover of Texas utility Energy Future Holdings. But he found that 95% of leveraged buyouts involved companies with an enterprise value (debt plus equity) below $1.1 billion, or roughly the upper bound of the small-cap universe. The same idea was revealed in a recent article in the Financial Analysts Journal.
Another conclusion, maybe less startling: The difference between success and failure usually came down to purchase price. The dividing line seemed to be seven times cash flow. When PE firms paid more than seven times earnings before interest, taxes, depreciation and amortization for a company, their chance of success plummeted, regardless of how much managerial magic they threw at it.
“The 25 percent of the cheapest deals accounted for 60 percent of the profits,” Rasmussen said. “The most expensive 60 percent of deals accounted for 10 percent of profits.”
Bain executives weren’t enthusiastic about the results, Rasmussen told me. The study undermined one of the principal justifications for the rich fees and carried interest private-equity executives take before distributing profits to their investors. Those executives brag about their scientific approach to managing businesses, but Rasmussen concluded that their most important skill was finding cheap companies that could pay back the debt they loaded on.
A significant proportion of PE returns comes from simple deleveraging, he said, since every dollar spent to pay down debt not only increases equity but reduces the risk of bankruptcy. That increases the odds of a higher price/earnings multiple when the company is sold or taken public.
“Once you get the deleveraging flywheel going, you can see very impressive equity returns,” he said.
Rasmussen was well prepared for his analytical assignment at Bain. The son of a Washington lawyer, he was a math whiz at St. Albans School but switched to history and literature at Harvard (while working part time for Bridgewater Associates constructing futures trading models). He graduated summa cum laude from Harvard and published a successful book, “American Uprising,” based on his senior thesis about a slave uprising in Louisiana, before becoming one of the first undergrads Bain hired directly out of college.
After four years at Bain he went to Stanford Business School, where he studied under Charles Lee, former head of global equity research at Barclays Global Investors. While there Rasmussen and a classmate built a trading model based on some of what he’d learned at Bain, using computer screens to find small, cheap public companies with lots of leverage. They added machine learning techniques to predict which ones are most likely to pay that debt down. (The biggest predictor is their past tendency to pay down debt, similar to the good-country/bad-country pattern economists Carmen Reinhart and Ken Rogoff observed in their 2009 book “This Time It’s Different: Eight Centuries of Financial Folly.”)
Rasmussen started managing money for friends and family at Stanford and went to work at his Verdad Capital full-time after graduating in 2015, resisting the allure of Silicon Valley for crunching numbers in search of cheap small stocks. In a break from industry practice, Rasmussen charges a 1.5% management fee and no performance fee instead of the usual 2 and 20. His goal is to become the “Vanguard of the private equity industry,” with low fees and transparency to counter the high-fee, opaque nature of most PE funds.
Three years in, he’s got about 20 clients and just $20 million in assets. His returns have made a gold-mining ETF look stable. After an 86% net return in 2013, his fund lost 10% in 2014 and 22% in 2015. He’s up 26% this year, for a return since inception of 14.6% a year, compared with 11% for the Russell 2000 small-cap index.
That’s not quite the performance he might have expected from his research at Stanford. A study of returns from 1965 to 2013 showed a leveraged small-cap strategy would have returned 25% a year, well more than private equity, where 10-year rolling annual returns have swung between 10% and 15% for the past decade. His analysis also showed that a machine-learning system could predict with 65% accuracy the likelihood of a company paying down debt in the following year, one of the most important predictors of future returns.
At Verdad, the computer ranks every one of 10,000 small-cap stocks trading on exchanges around the world. The machine-learning algorithm then picks the top 150 on the basis of predicted debt paydown. From there, Rasmussen does fundamental analysis to make sure the computers haven’t picked up on one-time asset sales or other events that would skew the prediction. Finally he selects stocks based on their correlation with other portfolio holdings as well as the correlation of the markets they sell products into, to avoid concentration. Another measure he likes is borrowed from Stanford prof Joseph Piotroski: Assets turnover, or assets/revenue, which shows how efficiently a company is using its capital.
Rasmussen can’t discuss the stocks in his portfolio, which change frequently, but his taste in companies is visible on SumZero, an investment website where he’s consistently one of the top-rated analysts. Quad/Graphics is typical: A longtime player in the viciously competitive magazine and direct-mail business, the Wisconsin company reported a $642 million loss last year on falling revenue as it wrote down poorly performing investments in Latin America. Quad/Graphics also sports $1.3 billion in debt, nearly equal to the market value of its stock.
“Any fundamental analyst is going to say `Look, they sell magazines, retail inserts and direct mail, all declining industries,’” said Rasmussen. “If you extrapolate those trends into perpetuity, yes, the value is extremely low.”
But the company also paid down $153 million of that debt this year and began a cost-cutting program late last year that helped boost free cash flow in the first half to $179 million from $40 million a year earlier. Better yet, it’s selling for less than six times cash flow and, Rasmussen thinks, could be a buyout target for somebody like RR Donnelly’s soon-to-be spun out LSC Communications.
Other stocks he likes include Tallink, an Estonian ferry operator; Ausdrill, an Australian mining services company; and Nihon House Holdings, a Japanese wooden home builder.
One reason Rasmussen thinks he can beat the PE boys at their own game is he can now buy PE-type stocks on the public markets for less than they cost in the private market. He doesn’t have to pay a control premium of 20% or more, for one thing. But competition also has driven up the price of private companies in the under-$1 billion range.
Investment banks like Goldman Sachs “have gotten so efficient and so good that anything with $30-$40 million in EBITDA is going up for auction,” Rasmussen said. “Anything with a $400 million enterprise value in the private market is going to attract interest from Apollo, KKR, Bain -- they’re all going to be at that auction.”
Price matters because the typical PE firm puts 60% leverage on an acquisition. At a purchase price of five times cash flow, debt should equal about three times EBITDA, and interest should consume about 30% of those pretax earnings, generating a free cash flow yield, or cash available after paying all the necessary bills, of about 20%. At 10 times EBITDA, interest chews up 60% of cash flow and there’s no free cash flow left over to pay down debt or cushion against financial shocks and insolvency.
Private-equity firms have powered ahead into this new, higher-priced market. The average purchase price in 2004 was seven times EBITDA, he said, but this year it’s climbed to 11 times.
“Investors who think they’re going to get historical PE returns with this strategy are wrong,” Rasmussen said. That’s why he started a hedge fund instead: “I can’t believe how cheap you can buy things in the public markets.”
