654. Is the Public Ready for Private Equity?

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Speaker 1 Let's say you find yourself with some money to invest. Where do you want to put it? Maybe you really like sports and you think you're good at picking winners.
So should you go heavy on sports betting?

Speaker 1 Sports betting, zero sum. And there are fees.
So your expected return is negative. So you better get some fun out of sports betting or you shouldn't do it.
All right.

Speaker 1 So that's probably not a good investing option. Any other ideas? The worst are lotteries.
The lottery, your expected return is terrible. How about investing in cryptocurrencies?

Speaker 1 Crypto is very volatile, but if you're paying low fees or low transaction costs to trade, it's a fair bet. Do you know if crypto is going to go up or down? I don't.

Speaker 1 Can you put some of your portfolio in it? Probably some. So how about the tried and true method of buying some stock shares of a big publicly traded firm?

Speaker 1 Or even better, maybe a low-cost index fund that includes a lot of stocks. You buy a stock at competitive fees or an index fund in particular.
It's a fair bet with a positive expected return.

Speaker 1 That's awesome. Over time, that's how you build wealth.
There are now decades of research showing that low-cost index funds do offer good returns at a relatively low risk.

Speaker 1 But what if I told you that there is an even better bet, an investment category that has been outperforming stocks over the past 40 years?

Speaker 1 The problem is this investment wasn't available to retail customers. It was mostly for institutional and ultra-wealthy investors.
But that seems about to change.

Speaker 1 On August 7th, President Trump signed an executive order called Democratizing Access to Alternative Assets for 401k Investors.

Speaker 1 Those assets include crypto, real estate, private credit, and the big one, private equity investments.

Speaker 2 This is a very big deal. The executive order has told the Department of Labor and the SEC, make sure you make this happen and make sure you don't go after anyone who tries to do this.

Speaker 2 That is the only opening that the industry needs to go forward.

Speaker 1 And the industry is going forward. Shortly after the executive order was signed, the investment giant Blackstone launched an ad campaign called Eureka.
It's California, 1849, the gold rush.

Speaker 1 We finally made it. Now let's go get that gold.

Speaker 1 The best investors see the bigger picture. That's why today, Blackstone is investing in the picks and shovels of tomorrow, like data centers and energy solutions.
We're going to need more shovels.

Speaker 1 Delivering prudent performance for 40 years, Blackstone.

Speaker 1 In the 40 years that Blackstone has been around, they haven't really advertised to regular investors. They didn't have to.

Speaker 1 As one of the biggest private equity shops in the world, they were being flooded with money from pension funds, sovereign wealth funds, and endowments.

Speaker 1 But lately, the bloom is off that rose, and private equity firms are looking for new investors. So, today on Freakonomics Radio, for everyday investors, is this a golden opportunity or fool's gold?

Speaker 3 This is Freakonomics Radio, the podcast that explores the hidden side of everything with your host, Stephen Dubner.

Speaker 1 If you've been listening to Freakonomics Radio for a while, you know we have made several episodes about the private equity industry. One of them was called, Do You Know Who Owns Your Vet?

Speaker 1 Another was called, Are Private Equity Firms Plundering the U.S. Economy?

Speaker 1 We also spoke with Lena Kahn, former chair of the Federal Trade Commission, about whether private equity firms gain too much power by buying up dozens or even hundreds of smaller companies within the same industry.

Speaker 1 Why have we spent so much time on this topic? Well, because private equity firms are thought to control about 20% of U.S. corporate equity.
That's up from around 4% just a couple decades ago.

Speaker 1 So in all those episodes, we tried to learn how this private equity revolution is affecting consumers, employees, and other stakeholders. What we haven't talked about is how it's affecting investors.

Speaker 1 in part because until now, retail investors couldn't get a piece of private equity. But now that they can, we thought it was time for another episode and a new kind of expert witness.

Speaker 2 I'm Elizabeth DeFontenay and I'm a professor of law at Duke University.

Speaker 2 My research is primarily in corporate law and corporate finance, but my favorite topic and my special focus has to do with private markets.

Speaker 2 So private equity, venture capital are the primary ones, private credit, more recently.

Speaker 1 What attracted you to this field of research? I know you worked worked in corporate law for a while doing mergers and acquisitions and private investment funds.

Speaker 2 I had always intended to be an academic, but coming out of law school, I knew that I wouldn't have anything very interesting to write about unless I'd actually practiced for some period of time and gotten to understand the real world.

Speaker 2 I found that I loved it.

Speaker 2 My practice was in covering private equity soup to nuts, really from the beginning with helping set up private equity funds, but then also once the fund was raised, with helping advise the funds themselves on how they deployed their capital that they had raised.

Speaker 2 Part of that was helping them acquire companies, doing mergers and acquisitions, and the other part of that was in financing those mergers and acquisitions. Big leverage buyouts require a lot of debt.

Speaker 1 What kind of firms were you working with?

Speaker 2 These were typically big private equity sponsors, the major ones that folks have heard about, but from all across the country.

Speaker 1 You said that you enjoyed the work because you got to know and understand how the real world worked. What was different once you got into the practice from what your perception was outside?

Speaker 2 Law school, by design, is very academic, more theoretical and case-based. Once you start practicing law, the world looks very different.
It was incredibly fast-paced. It was incredibly exciting.

Speaker 2 I realized that the private equity sponsors were really the most fun clients you could possibly work for because they are incredibly smart and incredibly fast-moving.

Speaker 2 They are really sophisticated in what they do.

Speaker 1 Why didn't you stay?

Speaker 2 The hours were extraordinarily long because I was practicing during the lead up to the financial crisis when we were in a big private equity boom. The deals being done were enormous.

Speaker 2 They were happening incredibly quickly. The valuations were sky high.
Everybody was working more than is humanly possible. And then the financial crisis happened.

Speaker 2 Most of the financing for these leverage buyouts needed to be restructured. I was primarily advising on the financing side.
So that meant a lot of work on that end as well.

Speaker 1 Your bio says that your research is focused on, quote, how market actors behave in the less regulated spaces of the financial markets. Where does private equity fall on the regulation spectrum?

Speaker 2 Private equity certainly falls in the less regulated side of the spectrum. This really covers the whole range of what it is that private equity does.

Speaker 2 The first thing that they do, of course, is raise capital from big institutional investors, typically, up until now.

Speaker 2 That side of financing is extraordinarily lightly regulated. Securities regulation is very powerful, very burdensome, but that's really focused on the public markets.

Speaker 1 If I'm a private equity firm, I can raise money from, let's say, a university endowment or a pension fund, and that investment comes with, it sounds like very little scrutiny, correct?

Speaker 2 That's exactly right. They can raise an unlimited amount of capital without any disclosure obligations and very few obligations even to their own investors.

Speaker 1 Aaron Powell, Jr.: Is that necessarily a problem?

Speaker 2 It can be a problem if the fund itself is doing something where we would like more information.

Speaker 2 For example, hedge funds, the big critique of hedge funds was they were raising this enormous amount of capital and no one actually knew how many funds were out there, what their size was, what they were doing, and that perhaps contributed in part to the financial crisis of 2008, 2009.

Speaker 2 With private equity, I think there's less concern in terms of having systemic implications for the economy causing a financial crisis.

Speaker 2 The concerns that we might have pertain more to what it is that they are doing when they are entering a particular industry. Are there antitrust concerns? Are there labor law concerns? Aaron Powell.

Speaker 1 If we think about a private equity firm doing roll-ups within a particular industry, maybe it's accounting practices, funeral homes, whatever it is, is there any kind of complicated dancing that goes on to avoid anti-competitive regulation?

Speaker 1 I've read a little bit about something called the Hart-Scott Rodino threshold of around $120 million.

Speaker 1 Are there ways to maybe consistently come in just under that number when you're rolling up a lot of firms in one sector?

Speaker 2 This is why private equity has done such a successful job at entering smaller markets.

Speaker 2 There is just inevitably much less antitrust scrutiny when we're talking about small businesses because it's thought that there are so many of them and they're so small that no one is going to have any market power.

Speaker 2 When you're acquiring lots of small firms, you're not going to trigger reporting thresholds to the antitrust authorities.

Speaker 2 The concern is that these markets are small enough that no one is really paying attention. And if you acquire enough of these firms, you can actually start exercising market power.

Speaker 2 A very big example of that was in anesthesiology markets.

Speaker 2 There was a case brought in Texas under the prior administration, focused on the extreme rise in prices in the anesthesia market as a result of private equity entering that market.

Speaker 1 Should we expect that to be just the tip of the spear and see more and more of that going forward?

Speaker 2 Certainly. That is the easiest way to make money in business in general.
Monopolize the market or at least eliminate competition and raise prices. Anyone is going to try to do that.

Speaker 2 The question is, why hasn't anyone done it before? And it's precisely because private equity has this big comparative advantage in finding firms and reaching them and convincing them to sell.

Speaker 1 Where does that comparative advantage come from, Elizabeth? Is it mostly just because these are smart, organized, motivated people?

Speaker 2 That's certainly part of it. The other part of it is their entire business model is acquiring firms.

Speaker 2 If you think of a large company in some industry, their main job is delivering that service, not so much doing mergers and acquisitions.

Speaker 2 Whereas if you are a private equity sponsor, your entire focus is on acquiring firms.

Speaker 2 They are incredibly good at sourcing deals, finding people who are willing to sell their companies and reaching out to them.

Speaker 1 The number of physician practices in the U.S. that are owned by private equity investors today is up around 700% since 2012.

Speaker 1 That's just one of many sectors or industries where private equity investors have acquired a great number of different types of firms.

Speaker 1 If that's a downstream effect of the private equity and private credit boom that was assisted in large part by those banking regulations to keep banking funds out of that investment stream, how do you feel about that as a trade-off?

Speaker 2 There's certainly a concern about what it is that private equity invests in, because there's been a significant expansion, not just in the size of private equity and private credit, but also in their reach.

Speaker 2 They have reached industries that used to never have really third-party equity financing before.

Speaker 2 Things like accounting firms, things like now law firms in places like Arizona that allow that, lots of spaces in healthcare, residential housing.

Speaker 1 Car washes, pawn shops, et cetera.

Speaker 2 Absolutely. The big debate there is, Is this beneficial in the sense that these were undercapitalized markets held by mom and shops before.
Now we are getting more sophisticated capital.

Speaker 2 We're going to get a better product for consumers. Or is there the risk that these people know the overall pricing in that market?

Speaker 2 And so they are able to buy up enough that they're able to raise prices for consumers and possibly have a decline in quality.

Speaker 1 I see there are something like 19,000 private equity funds in the U.S., which strikes me as quite a few considering it's a relatively new industry.

Speaker 1 That's more than there are McDonald's locations in the U.S.

Speaker 1 How did it get so big?

Speaker 2 Private equity started up really in the 1980s. This is a very young asset class, but it is already very crowded.

Speaker 2 Most of those funds that you mentioned are going to be small funds, but then there are the behemoths, the Apollos and KKRs and Blackstones that are running absolutely massive funds.

Speaker 2 And those asset managers are the ones that are going for retail capital most aggressively.

Speaker 1 Talking to Elizabeth DeFontenay, I got the sense that it might be useful to go a little deeper on the private equity industry, some history and some broader perspective.

Speaker 1 I asked if she had anyone to recommend.

Speaker 2 Steve Kaplan, he's fabulously smart, brilliant man, has been involved with private equity forever, just sort of an economics legend.

Speaker 1 Kaplan is a professor at the University of Chicago. It was Kaplan's voice we heard in the open of this episode talking about some of the worst investment options.

Speaker 1 Sports betting, your expected return is negative. The lottery, your expected return is terrible.
Crypto is very volatile.

Speaker 1 When it comes to private equity, Kaplan has decades of his own research to draw from. I did some of the first work on leverage buyouts back in the 80s.

Speaker 1 It was a new phenomenon back then that companies were being bought with a lot of leverage. There was a lot of controversy.
I guess there still is.

Speaker 1 And I wrote my doctoral dissertation about leveraged buyouts. Private equity was new.
You couldn't just go online. So I had to scrounge around for data to find out what was happening.

Speaker 1 The bottom line results were that the operating performance of the companies that were taken private with leverage buyouts improved.

Speaker 1 The story that they gutted the companies and the companies didn't do very well was not true then. It's still generally not true.

Speaker 1 But, Kaplan acknowledges the industry has had trouble with its brand.

Speaker 1 Just to define, private equity is equity that's not publicly traded, that you can't just buy on the stock market. Venture capital is a form of private equity.

Speaker 1 Real estate can be a form of private equity. And leverage buyouts can be a form of private equity.

Speaker 1 Leverage buyouts are what these transactions were called in the 1980s because you borrowed a lot of money to buy the companies.

Speaker 1 In those days, which was the height of the junk bond era, the deals were funded with 80 or 90% debt. These were very highly leveraged.
Then what happened in the early 90s, we had a recession.

Speaker 1 A lot of these deals defaulted. They were over-leveraged.
Something like 40% of the transactions done in 1987 and 1988 ended up defaulting. Leverage buyout became a bad word.

Speaker 1 The industry said, oh, we're private equity now, not leverage buyouts. And that has stuck.
What's also interesting is they're much less leverage today.

Speaker 1 I think the lenders decided correctly that 80 or 90 percent leverage on a company was too much.

Speaker 1 Since the last 15 years, the average leverage in a deal is more like 50, 60 percent.

Speaker 1 So how does a leveraged buyout typically work? Let's say I buy a company for $100 million.

Speaker 1 I can borrow that $50 million

Speaker 1 probably today at 8 or 9%.

Speaker 1 Then I'm going to put in $50 million of equity. So it's 50 of debt, 50 of equity.
If I then

Speaker 1 increase the value of the company by

Speaker 1 let's say $100 million,

Speaker 1 it goes from $100 million to $200 million. And I do that by figuring out ways to make the company grow faster

Speaker 1 or cutting some costs, making the company more efficient. It's generally a combination of those things.
So let's say the value goes to 200 million.

Speaker 1 At that point, I repay the debt of 50, and what's left? 150.

Speaker 1 And I originally put in 50 million of equity. So my 50 million of equity has grown to 150 million.
When I exit, that's three times my money, which is an attractive return.

Speaker 1 Those outsized returns have drawn critics. Kaplan thinks a lot of the criticism of private equity firms is unfair.
There is certainly a media slant against them.

Speaker 1 I think it comes back to the 80s where a lot of these deals defaulted. When a deal does go bad, companies don't do well.

Speaker 1 People lose their jobs in the bad deals, and they're very visible and that gets attention. The successful buyout investors make a lot of money, which also gets attention.
Those variables come into

Speaker 1 negative perception and an incentive to write negative articles. Negative gets more attention than positive.

Speaker 1 Okay, so let's hear about the positives. How about the performance of private equity investments? There's first what happens at at the company level.
Do the companies become more efficient?

Speaker 1 You read a lot of things that are just wrong about this because the popular press and some of the authors will focus on the failures.

Speaker 1 But when you look at a large sample of deals, which is what I did back in the 80s and other people have done subsequently with better data sets, every single one of those large sample papers that is done well finds that the buyout companies outperform in terms of getting more productive, more efficient, or more profitable.

Speaker 1 For every deal that you see that there's this negative story, there are deals where there are very positive stories. The bottom line is at the company level, the performance is good.

Speaker 1 When you compare it to the SP 500, for example, which is the largest public companies and is sort of a measure of how public companies are doing, those companies have less leverage than the leverage buyout companies, but they also have more tech.

Speaker 1 Tech is a different form of risk.

Speaker 1 People who've looked at the risk of the buyout funds and compared it to the risk of the S P 500 find that the greater risk in the S P 500 companies more or less offsets the leverage in the leverage buyout companies.

Speaker 1 So the risk, they're kind of the same. It's a little bit surprising, but they work out to be the same.

Speaker 1 So when Kaplan compares the investment returns on public stocks and private equity, what does he find? The way I like to look at it is for a given year,

Speaker 1 look at all the buyout funds that are raised in that particular year and then follow their performance for investors going forward from almost every year before 2020, those funds, net of fees,

Speaker 1 beat the SP 500. There was one year where it didn't, and there were a couple of years where it was close, but the other, what is that, 27 years, 25 of them beat the SP 500, which is really remarkable.

Speaker 1 That's part of the reason so much money came in to private equity. Now, the 2020, 21, and 22 funds, those funds are not beating the S ⁇ P 500.
So what happened?

Speaker 1 Why, after all those winning years, did private equity funds fall behind the public markets? Remember, 2020 and 21, we were in the middle of the pandemic. It was a very volatile time.

Speaker 1 After dipping at the start of the pandemic, stock market roared. Interest rates were very, very low.

Speaker 1 If you looked at the prices people were paying in both buyouts and venture deals, they were very, very high.

Speaker 1 What happened is we had inflation, interest rates went up, so that leverage in the buyout deals started to really bite because their interest payments went up.

Speaker 1 On the venture side, the multiples that people were willing to pay of cash flow, of revenue, of earnings went down. The growth people were expecting didn't come so much.

Speaker 1 People made mistakes on the investing side in 2021. Then they also got hurt by the increase in interest rates, which may or may not have been unexpected.

Speaker 1 This leaves private equity funds with assets that are much harder to sell. All these deals in 2021 and 22, they were done at high prices.

Speaker 1 As a result, private equity firms have not sold as many of those transactions as they would normally do.

Speaker 1 The number of deals that are still private and haven't been either taken public or sold to other companies or sold to other private equity is unusually high.

Speaker 1 That has created pressure on the general partners because their investors, the limited partners, don't have more money to give them.

Speaker 1 They're waiting to get the returns back from the investments in 2021, some 2019, some 2022. They're waiting to get that money back before they commit more.
to the private equity funds.

Speaker 1 The fundraising for new funds has actually been down the last two years. The industry actually is getting smaller in terms of commitments.

Speaker 1 So does this mean that private equity's overperformance is a thing of the past? I'm a bit skeptical of that explanation.

Speaker 1 At the company level, private equity has consistently made those companies more efficient. That's a real thing, regardless of interest rates, and I would expect that to continue.
The buyout investors

Speaker 1 are still investing more or less the way they invested 10, 20 years ago. So that leads you to believe on the institutional side that it's reasonable to keep doing what you've been doing.

Speaker 2 Overall, over private equity's roughly 40-year history, the performance within private equity has been superior to the public markets on average.

Speaker 1 That, again, is Elizabeth DeFontenay. She agrees with Steve Kaplan about private equity's past performance, but she is less sanguine about its future performance.

Speaker 2 What we have to understand is that that outperformance has declined over time. There was significant outperformance in the beginnings when this was a very niche market.

Speaker 2 As more capital has flowed into the market, everybody is chasing the same deals. The valuations go up.
It's more expensive for them to buy companies. and they're getting a lower return, inevitably.

Speaker 2 That's not a bad thing. It just shows that these markets have matured.

Speaker 2 But if they have matured to the extent that they are very crowded, then in fact, there is no real advantage to someone in moving from the public markets to the private markets.

Speaker 2 Private equity has essentially converged with the public markets. There really is no outperformance, even for very sophisticated institutional investors.

Speaker 1 So, if a private equity investment isn't better even for a sophisticated institutional investor, how's it going to work out for everyone else?

Speaker 1 Coming up after the break, we ask whether retail investors have finally been invited to join a party just as it's winding down.

Speaker 2 I think the party is over in the private markets.

Speaker 1 I'm Stephen Dubner. This is Freakonomics Radio.
We'll be right back.

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Speaker 1 We're talking today about how a new executive order from President Trump will allow what are called retail investors, anyone with 401k, for instance, to invest in private equity funds.

Speaker 1 I have been speaking with Elizabeth DeFontenay, a law professor at Duke.

Speaker 1 So, Elizabeth, I am for the most part a boring buy-and-hold investor with my weapon of choice being low-cost index funds.

Speaker 1 Most of my friends in finance make constant fun of me, and I have no problem with that because I'm very happy with the way it's worked out.

Speaker 1 But I also sleep well at night, and I also don't feel like my money is being used for stuff that I don't know and I might not like. Yes.
But let's say I decide now, oh, you know what?

Speaker 1 The private markets are being opened up in this nice, accessible way.

Speaker 1 It makes me think of how John Bogle talked years ago with Vanguard about let's democratize this and make investing easy and available and cheap for everybody.

Speaker 1 If I squint, I can kind of tell that same story about what's happening right now with retail investor access to private equity.

Speaker 1 But you're saying it's not going to be nearly that good, it sounds like, yes?

Speaker 2 I think it certainly is not going to be that good for several reasons. The first is is that investing in the private markets is far from cheap.

Speaker 2 The compensation paid to managers of private equity funds, venture capital funds, private credit funds is enormous.

Speaker 2 They get 20% typically of any profits from their investments, and they get something like a 2%

Speaker 2 management fee every single year. 2% of the entire fund size every single year that you're invested.
Compare that to an index fund invested in public securities.

Speaker 2 Now you can get those essentially for free. Compare that again to the private markets.
The cost is incredibly high.

Speaker 2 But more than that, you will never actually be able to access the entire private markets because these are private companies.

Speaker 1 Will retail investors not get access to the same private investments as institutional and inside investors? Are they essentially getting a second-tier portfolio choice?

Speaker 2 That is almost certainly going to be the case. If they don't want want you to be invested in their company, they don't have to sell to you.

Speaker 2 Think about it from the perspective of a fund manager or a private company that is looking for outside capital. In both cases, they will always prefer the larger check than the smaller check.

Speaker 2 Retail investors are very small checks, and so they are not going to be seeking out retail capital unless these are investments that are on the worst end of the spectrum.

Speaker 1 Other than the fact that private equity firms are in the business of making money and getting retail investing will make them a lot more money by fees alone, if nothing else, why is this happening now?

Speaker 1 Blackstone and KKR and Apollo and all these big firms, why is it now that these investments or some version of them are going to be made available to retail investors?

Speaker 1 I understand there's been lobbying going on for years and years, but what led to this moment?

Speaker 2 That is the perfect question to ask, which is why are they suddenly offering these investment opportunities to retail investors?

Speaker 2 I think that uncovers exactly the danger of why we should be worried about retail investors entering these markets.

Speaker 2 What has happened is the private equity industry and the venture capital industry and the private credit industry have completely tapped out institutional money.

Speaker 2 In order to keep growing at the rate that they want to grow and earning additional compensation, these sponsors of private funds need to now access retail capital.

Speaker 2 They're not doing it as a favor for retail investors. They are doing it because they have tapped out the institutional money.

Speaker 1 But wait, Elizabeth, I've seen their TV commercials. They are doing it as a favor.
They're offering me access to their amazing private equity gold rush. Why wouldn't I want in?

Speaker 2 I'm glad to hear that. That's great.

Speaker 1 But that is the pitch, essentially, yes? This fantastic money generating engine that we've perfected.

Speaker 1 by financial engineering over the past few decades, we are now making it available to you, Elizabeth, to you, Stephen, and to everybody else.

Speaker 2 Great. Well, this is the time to talk about whether it is, in fact, a fantastic money-making opportunity.

Speaker 2 The thought is that we can now allow retail investors perhaps to diversify their investments by investing in the private markets, getting therefore a bigger reach in terms of what kinds of companies they are invested in.

Speaker 2 If you want to know whether this is a good idea, talk to the big institutional investors who are invested in private equity and venture capital right now.

Speaker 2 They will tell you they are extremely unhappy. They have deployed all this capital and in fact they're not getting any cash back.
These investments are tied up in illiquid investments.

Speaker 2 The engine of private equity and of venture capital is so overcrowded that ultimately they're not in fact getting the returns that they want.

Speaker 2 Institutional investors are pulling back from private equity and venture capital. If they were really permanent money-making machines, they wouldn't be doing that.

Speaker 2 The investors who are most likely to profit in these markets are currently quite unhappy.

Speaker 1 So the more I listen to you, Elizabeth, the more I feel like we're at this moment where the main street money, what smart investors call the dumb money, is being invited to this party right as all the good people have left the party and that they probably won't do very well with these investments.

Speaker 1 They might actually do poorly. Is it uncharitable of me to be so skeptical?

Speaker 2 Not at all. I think you're exactly right.
I think the party is over in the private markets. They will continue to do well and they will continue to expand their reach.

Speaker 2 But the idea that this is going to be this incredible investment opportunity for retail investors is very misguided.

Speaker 2 All of the messaging to retail investors is that you are losing out by being stuck in the public markets.

Speaker 2 Here is this incredible opportunity where you're going to have massive outperformance relative to your current investments. I think neither one of those things is true.

Speaker 1 Let's talk about the Trump administration's policies. What has happened so far that's changed for the private equity and private credit industries?

Speaker 2 The major thing that has happened is that the Trump administration put out an executive order.

Speaker 2 essentially directing the SEC and the Department of Labor and anyone else who is relevant to do everything they can to allow access for retail investors 401ks to the private markets.

Speaker 2 Their oversight of 401k plans is very crucial because they set the standard for what plan managers have to do and what they should not do.

Speaker 2 The executive order defines private markets extraordinarily broadly. They are envisioning investments not just in private equity and private credit, but also venture capital.

Speaker 2 They specifically list cryptocurrency as a market that they would like to see offered in 401k plans.

Speaker 2 The average person person might not know this, but 401k plans over time have gotten more and more conservative in the sense of offering primarily and oftentimes exclusively index funds of public securities.

Speaker 2 These are the so-called target retirement funds that many of us are familiar with, where you set the date for when you expect you're going to retire, and then all of that money is put into index funds, a mix of publicly traded stocks and publicly traded bonds that adjusts over time.

Speaker 2 These investments have performed extraordinarily well over time, and they are incredibly low cost.

Speaker 2 What we are talking about now is reintroducing a world in which 401k plans include offerings that are high cost and invested in something potentially illiquid. So that poses a danger as well.

Speaker 1 Can you tell us what you know about the lobbying efforts from the private equity industry that made this happen?

Speaker 1 I would imagine it's not a hard sell because there's been such a revolving door between the financial industry and government over the past bunch of decades, but I don't know it took a while.

Speaker 2 It certainly did take a while. Part of that was when institutional money had not been tacked out yet.
Private equity didn't really want retail capital because it just adds a lot of headaches.

Speaker 2 It's only when things started slowing down for them with institutional money that suddenly they were very eager to court retail money. These are very small checks and people that might sue you.

Speaker 2 What the executive order did is very interesting. It said we want to make it so that 401k plan managers are protected from any litigation over this.

Speaker 2 There are federal statutes that set the rules for what you're allowed and not allowed to do. And so the executive order itself can't protect anyone from litigation.

Speaker 2 But what what it has done is created more of a danger of litigation for plan managers because they can get sued very easily if they offer something that is high cost when there is a lower cost alternative.

Speaker 2 This executive order is taking the position that if they don't offer private assets, then they are not actually giving a good product.

Speaker 1 But you're also saying that you do see the industry continuing to grow.

Speaker 1 It sounds like you're saying it's going to grow because they're going to be successful in harnessing this new stream of retail money, yes?

Speaker 2 Yes.

Speaker 2 It's very tempting to believe that by being forced to invest just in public securities, these boring asset classes, that investors are being kept from some great opportunity and they're being harmed.

Speaker 2 So I don't think it's hard for the industry to promote that message. Retail investors are being poorly treated.
They're given second-class citizenship.

Speaker 2 Whereas all of these fancy investors can invest in these these great things and get these great returns and you're losing out. All of these arguments, if you push on them, don't hold up.

Speaker 2 But the messaging is so easy to do and it is so convincing.

Speaker 1 Let's focus on crypto.

Speaker 1 Even if it were not the case that Trump himself and his family are big crypto players, investors, beneficiaries, why is crypto investing like the type that you just described for retail investors a bad idea in your view?

Speaker 2 The big problem with the crypto industry is that we have so little sense of whether the pricing is efficient or not, whether it actually is tied in some way to the value of the underlying asset.

Speaker 2 These are often investments that are also highly illiquid. It's really hard to transfer cryptocurrency.

Speaker 2 These are very opaque markets that are very different from what retail investors usually invest in when they're investing their 401k money, where we kind of understand how the returns work and we have some understanding of what those returns are based on.

Speaker 1 If you were a crypto firm CEO or a crypto fund or a fund of crypto firms, how would you be thinking about this near-term opportunity?

Speaker 2 They probably already are reaching out to 401k plan managers, trying to find some way to get onto the list of plan offerings. Now, here is where it's interesting.
There are several options.

Speaker 2 One is that these offerings are provided as separate investments that you can put some or all of your 401k money in.

Speaker 2 But I think the real goal and the real danger is that all of these private market investments will make it into target retirement funds.

Speaker 2 So that now when you buy a target retirement fund, it will include not just publicly traded securities, but it will include some small piece of investment in the private markets.

Speaker 2 You might say, this is great. Now we have some diversification and it's a small piece.
You're in fact not putting too much of your money at risk. But that's not the right question.

Speaker 2 The right question is, is this actually a good investment? And that really depends on what the returns are likely to be and also what the cost is likely to be.

Speaker 2 One way to think about it is, yes, I can get diversification for my 401k just by taking some of it and putting it under my mattress, right? That's diversification.

Speaker 2 I'm going to get different returns for the mattress money and the publicly invested money, but that doesn't mean it's a good idea.

Speaker 2 If it's buried in a target retirement fund, no one is going to know and no one is going to pay attention. That is going to be incredibly easy money for these private fund sponsors.

Speaker 2 And that is exactly for them the promised land. That is what they want.

Speaker 1 One big difference between institutional and individual investors is that many institutional investors are accustomed to keeping their money locked up across a longer timeline.

Speaker 1 An individual investor with a 401k, meanwhile, may need faster access to their money. And that can be a challenge if your 401k is invested in private markets.
The hard part on the 401

Speaker 1 is that you need liquidity. That, again, is the U Chicago economist Steve Kaplan.

Speaker 1 When you're managing a pension fund, there you've got thousands of employees, and some will need liquidity at a certain time. And liquidity means means retiring.

Speaker 1 You'll have other people who are putting money in and you can kind of offset the people who are taking money out from the people putting the money in so the liquidity is manageable.

Speaker 1 When you have your 401k

Speaker 1 and you want to retire, you got to be able to take money out. If the investments are illiquid, that's potentially a problem.

Speaker 1 The solution that people are working on, and I think they'll solve this, is you'll set up the private equity investment as part of a larger investment. So, target date funds are very popular.

Speaker 1 Target date funds have right now public securities, some mix of stocks and fixed income or bonds.

Speaker 1 So, they'll add what's called a sleeve, an investment that's maybe 10%

Speaker 1 private that will go with the 90% that's public, that allows them to manage some of the illiquidity.

Speaker 1 And as long as they're priced in a fair and transparent manner, people will be able to move money in and out.

Speaker 1 So, where does Kaplan stand overall on the idea of individual investors and private equity? I'd say I'm mildly negative. There are at least three reasons why Kaplan is mildly negative.

Speaker 1 First of all, does too much money come in? If everybody says, oh, I have to do this, this is wonderful, does that further depress returns?

Speaker 1 Because you'll have more buyout firms trying to buy companies. That will mean, in all likelihood, more of the value goes to the sellers rather than to the investors.

Speaker 1 The second thing are the fees. The institutional investors are more or less investing directly into the buyout funds and venture capital funds.
Even directly, they're paying meaningful fees.

Speaker 1 It's like 15 times what you would pay for the SP 500. And then they get the 20% of the profits.
When you model that all out, that might be 5% a year.

Speaker 1 If you put it in a 401k type arrangement, there's going to be an additional fee on top of that. And that additional fee, at least in the retail vehicles that I've seen, is

Speaker 1 not trivial.

Speaker 1 The third question that is probably more of an issue on the venture side, but is also an issue on the buyout side, is which funds

Speaker 1 will you get access to? If it's a retail investor, they're not investing directly usually into the buyout funds or the venture funds.

Speaker 1 They're investing into a fund of funds, which then is picking the venture funds or the buyout funds.

Speaker 1 What you worry about there is that they'll get a different return from the return the institutions get. Elizabeth DeFontenay thinks that Steve Kaplan's assessment is correct.

Speaker 2 I agree with it completely.

Speaker 1 And she raises another important issue, asset pricing.

Speaker 2 What we all need to understand is that the public markets are the best possible scenario for retail investors because

Speaker 2 there is so much capital in that market and it's so liquid that securities in the public markets on average overall should be correctly priced. What that means is two things.

Speaker 2 One, retail investors can index the market. That is to say, they can, instead of picking and choosing their own investments, they can just hold the entire market.

Speaker 2 They get all of the benefit of the appreciation in those securities without doing any work.

Speaker 2 The second part of that is if securities are correctly priced in the public markets, they don't have to do any research. They don't have to do any due diligence.

Speaker 2 They essentially just free ride on everyone else. That has been enormously profitable for retail investors over the last several decades.

Speaker 2 It's hard to come up with a better investment than just indexing the public markets in the United States. When we move from there to having retail investors in the private markets, everything changes.

Speaker 2 These are opaque markets. The pricing is not public.
The markets are totally illiquid.

Speaker 2 What we now have to do is we have to pick and choose investments, or at least pick and choose investment managers to access the private markets.

Speaker 2 Inevitably, retail investors will be at an enormous disadvantage compared to the big institutional money that is already in the private markets.

Speaker 1 If I were hearing you from the private equity side, or one of the big investment funds that is now starting to offer private equity investment to retail investors, I would, no offense, Elizabeth, I would want to shut you up.

Speaker 1 I don't like the message that you're delivering.

Speaker 1 You're a law professor at a really good school at Duke, and you're saying that my messaging on these TV ads and on the lobbying to DC over the years, that this is the democratization of investing for access to great companies that are run by private equity firms.

Speaker 1 You are coming in with layers of doomsaying and prediction of poor outcomes. Do you get that heat from anybody? Is anyone telling you to shut up or is it just me imagining it?

Speaker 2 Not in a very serious way because the odds that retail investors are going to listen to me are very low.

Speaker 2 We are in an era of exuberance and an era of intense speculation by retail investors, including in the public markets. Everything is moving in the direction of go, go, go.

Speaker 2 I don't think my naysayer attitude is going to be particularly influential. It certainly has not been influential in terms of this administration's policies in terms of encouraging retail investment.

Speaker 1 Coming up after the break, welcome to the caveat emptor economy. I'm Stephen Dubner.
This is Free Conomics Radio. We'll be right back.

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Speaker 1 Americans hold a total of around $13 trillion in their retirement savings plans, including 401ks.

Speaker 1 I asked the Duke law professor Elizabeth DeFontenay how much of that $13 trillion will flow into private equity funds in the next few years now that the rules are being rewritten?

Speaker 2 If the industry gets its wish, we might see about 10% of that money being invested either directly or more likely indirectly in that market. That would be a massive amount of money.

Speaker 1 Your prognosis is that this is on average bad for retail investors. But what about the other constituencies in this whole ecosystem?

Speaker 1 I assume that the private equity firms themselves will do on average quite well from this change.

Speaker 2 Yes, exactly. The amount of money invested in 401ks is absolutely massive.
This would be a gold mine for them, for sure.

Speaker 1 Let's just talk about that fee, the standard 2 in 20.

Speaker 1 I could imagine that in this new era of retail investing in private equity funds, that fund managers will start competing on price and drive that management fee down.

Speaker 1 Have you seen any evidence of that?

Speaker 2 Certainly, we would expect with more capital coming in, we're going to see more competition on fees. I think that the fees will come down.
The question is, how many levels of fees are we paying?

Speaker 2 Imagine that we put retail investors into a big fund, and then we have that fund in turn go out and invest in a bunch of private equity and venture capital funds.

Speaker 2 The fund that the retail investors go into first, that one might charge low fees, and it might charge only a management fee, but then it's going to be invested in these other funds that in turn charge a 2 and 20 compensation model.

Speaker 2 When you layer on fees upon fees, that's a danger that I think retail investors are going to have no appreciation for.

Speaker 1 What about the portfolio companies that some of this money is flowing to? I assume it's also a benefit for them.

Speaker 2 It is. Financing will get cheaper for them.
They will be able to access capital very cheaply, even more cheaply than they are now. There's so much capital sloshing around the private markets already.

Speaker 2 Many people think too much capital, but if you then add on top of that 401k money, it's going to to be incredibly easy to raise money for pretty much anything in the private markets.

Speaker 1 What about the customers and employees of those companies? If more money is available for investing in those firms, theoretically that could make prices cheaper for customers.

Speaker 1 It could make wages higher for employees. I mean, it could, but do you think it will?

Speaker 2 That one's harder to say, I think. If you have much more capital in the private company space, they're going to be able to do more things than they were before.

Speaker 2 Probably you will see a growth in those companies and you'll see more hiring and so on. But in terms of the long-term effects on wages, that's a harder one to predict.

Speaker 1 I assume that this will provide millions of really good billable hours for lawyers as well.

Speaker 2 I think the law firms are very excited about this.

Speaker 2 We have the private equity sponsors who are very used to operating in the absence of regulation that are now suddenly going after retail investors where they will have to deal with at least some regulation.

Speaker 2 The federal statutes that deal with retirement money, the securities laws that deal with accessing retail money.

Speaker 2 There's a big clash of approaches here and the law firms are of course going to intermediate.

Speaker 1 So we were talking about the lack of transparency when raising funds, as these private equity firms do, raising investment funds that then they will deploy to buy companies that they put in their portfolio and so on.

Speaker 1 As retail investing in private equity rises, do you think that sort of, let's call it democratization of private equity will create more transparency?

Speaker 2 That's a really hard question to answer because the rules are not set up so that there will be more disclosure about their ultimate investments.

Speaker 2 We'll have to see if market pressures cause them to disclose more, but I think most likely that will not be the case because these retail investors are most likely to come in investing through a fund vehicle.

Speaker 2 The fund itself will not have to disclose to them very significant information about what the actual capital is being used for. I don't think we're going to see a big rise in company level reporting.

Speaker 2 With a public company, they are required continuously to provide disclosure about exactly what it is that they are doing and exactly what their financials are.

Speaker 2 When a private equity fund buys a company, that company is now itself private and therefore is not required to provide any public disclosure.

Speaker 1 How big of a concern should that be?

Speaker 2 It's a concern if we have reason to believe that public disclosure allows the system overall to operate more safely.

Speaker 1 It's hard to imagine that it doesn't, isn't it?

Speaker 2 I think that's right. The big advantage to avoiding public disclosure is that you have far more discretion to do whatever it is that you want to do and to do do it very quickly.

Speaker 2 That is the space private equity has always operated in and a space in which it is an expert.

Speaker 2 With public companies, the benefit is that they are much less likely to do something very concerning, something fraudulent, much less likely to violate the law.

Speaker 2 The difficulty for them is that they are very constrained, not just by the obligation to provide information to the public, but the public's reaction to everything that they do.

Speaker 2 The critique has always been that public companies are slower, they're less efficient because of this constant public scrutiny.

Speaker 1 Aaron Powell,

Speaker 1 if you take a step back,

Speaker 1 what I see as an acceleration of an economy that's already very generous to the investor class, or if you want to put it another way, to the wealthy.

Speaker 1 Is it inevitably bad for the overall economy and the people who work in the economy, the people who aren't ultra-wealthy, to have this financial engineering driving so much more investment in firms, even though it's coming in a kind of side door.

Speaker 1 Could you say that this might end up being a net positive, the rising tide lifts all boats argument? Or do you not feel we're heading in that direction?

Speaker 2 I think you can make an argument for how this could be good for at least firms within the economy and those who depend on firms, which ultimately is all of us.

Speaker 2 Venture capital would be a great example of that. Venture capital has been a bad investment, even for incredibly sophisticated investors over the last 20 years.

Speaker 2 Nonetheless, venture capital is crucial for economic growth. It is really an engine of innovation.
It's become particularly important as government investment in basic research has declined over time.

Speaker 2 We can hold two things in our head at once: venture capital, bad investment, venture capital, crucial for economic growth.

Speaker 1 That's a really lovely conflict you just posed. Where do you come down on that then? Let's say that you were trying to think this through from a regulatory standpoint.

Speaker 2 From a regulatory standpoint, my preference would always be not to try to trick people into investing in bad things. I don't fall on the side of wanting retail investors to jump into this market.

Speaker 2 We have a wealth of data on how retail investors behave. What we have already is evidence of how they have behaved in the public markets.

Speaker 2 When they were allowed to pick funds on their own, they made incredibly poor choices. We would love to believe that with time and education, they get better at investing.

Speaker 2 We don't find that to be true. They end up falling into high-fee products that perform badly for them.
That just eats away at people's retirement money.

Speaker 2 Call it paternalism if you will, but retail investors always do better when they are indexed in the public markets. That has been the absolute best possible investment for them.

Speaker 1 Even with that whole revolution that made it so easy to invest in the markets at such little cost, you're saying that the median investor is still making those basic mistakes?

Speaker 2 That's right, unless they are pushed into those products that are low-cost and diversified.

Speaker 2 The incredible revolution in retail investing has been when 401k started nudging investors into these low-cost plans. When they pick on their own, they make poor choices.

Speaker 2 My fear is we're moving back to the old world of trying to nudge them into products that charge high fees for something that they don't understand.

Speaker 2 And further, there are some real dangers in the sense that we are having retail money invested in products that are much less liquid. That creates a big danger of something equivalent to a bank run.

Speaker 1 I saw a poll result, a Harris poll, published in the Wall Street Journal. It said that only 10% of retirement investors are unhappy with their current investment choices.

Speaker 2 The real danger is this executive order pushes 401k managers to think: now I need to start offering private assets in my 401k plan, but I don't want to offer them on their own because then they'll look bad, they charge high fees, and so on.

Speaker 2 Instead, what we're going to do is lump them into a target retirement fund. That is the way that we will hook retail investors because they don't make those choices.

Speaker 2 They don't think about these things. They will just be pushed into those investments automatically.

Speaker 1 How do you think a multi-trillion dollar inflow of retail investors' money to private equity, how do you think that will affect the public stock markets generally?

Speaker 2 We're really doing everything we possibly can to one way or another, through regulation or deregulation, push money out of the public markets into the private markets.

Speaker 2 If there's an outflow of money in the public markets, then you might see a vicious cycle where fewer companies go public. If the public markets become too anemic, there is a danger there.

Speaker 2 You don't want the public markets to be too concentrated around a small number of firms because they serve such an incredibly important role of allowing investors to be completely passive investors.

Speaker 1 And the market for public companies has plainly been hit. There were 7,300 public companies listed in the U.S.
in 1996. As of last year, there were 4,300.

Speaker 1 And I realize I'm saying number of companies versus share of dollars, which may not be quite fair, but I'm going to assume that's a decent proxy.

Speaker 1 Does that concern you that public ownership has fallen so much?

Speaker 2 That's potentially a big problem because ordinary investors, most U.S. households, are confined to the public markets.

Speaker 2 If the number of companies shrinks too much, they may be in a position where they are invested in something that is not actually representative of the overall economy.

Speaker 2 And it might, in fact, be a source of risk as opposed to a source of opportunity. Now, there are several caveats to that.

Speaker 2 One is that in terms of the overall market capitalization, public companies have not been shrinking. The explanation is fewer companies, but bigger.

Speaker 1 NVIDIA, Apple, et cetera, et cetera.

Speaker 2 Exactly.

Speaker 1 So let me ask you this. U.S.
financial markets and the whole financial ecosystem, the venture capital industry and so on, have really been the envy of the world for decades.

Speaker 1 And if you look at the firms that have succeeded and the industries that have grown in in this country compared to others, it's really remarkable.

Speaker 1 Do you think this is going to either diminish the overall efficacy of our investing and startup system?

Speaker 1 Do you think it perhaps may give opportunity for other countries to grab some of that investing crown?

Speaker 2 You're asking exactly the right question, which is what will this actually do to firms that are venture capital owned and private equity owned?

Speaker 2 I worry intensely that in fact adding retail money to this will invite exactly the kinds of things that these companies have always said they don't want, which is more scrutiny, more regulation, certainly more litigation.

Speaker 2 So in fact, those companies will not perform as well as they had been. I never want to be understood as saying that I think private equity and venture capital are bad.
Quite the contrary.

Speaker 2 Those markets do all kinds of incredibly important things for the economy. But what makes them special is precisely the thing that is going to change if we add retail money to the mix.

Speaker 2 They thrive in markets where there is very little scrutiny and very little litigation.

Speaker 2 You cannot possibly think that adding significant amounts of retail capital is not going to lead to more scrutiny and more litigation. There's no way.

Speaker 2 And so, what we have will be venture capital and private equity 2.0 that will look very different and might, in fact be a worse product than 1.0.

Speaker 1 I feel like what you're describing now that we're just on the brink of, but it's it's coming, right? There doesn't seem to be much doubt that it will come, is there?

Speaker 2 That's right.

Speaker 1 I feel like it's a caveat emptor economy in a way that it's not been before. Am I overly pessimistic in thinking that?

Speaker 2 Not at all. That is the goal for many who think that we have regulated investment far too much and that in fact what we should have is just pure freedom of picking what investments you want.

Speaker 2 There are some compelling arguments to be made in that direction. I just think that empirically we know what's going to happen to retail investors.
They will make poor choices.

Speaker 2 The whole reason we have a public market and a private market has to do with the securities laws. These were laws that were adopted immediately after the Great Depression.

Speaker 2 Nobody at that point was willing to reinvest in the markets because they thought they were all fraudulent and that we couldn't trust the prices. That was the goal of the federal securities laws.

Speaker 2 We're in a moment now where we are really undermining that logic. We're back to a world in which anything goes.
Over the next couple decades, we'll see where it goes.

Speaker 2 We might end up in a moment where we have another big crash and we have to recreate that dichotomy once again.

Speaker 1 That again was Elizabeth DeFontenay at Duke. My thanks to her as well as to Steve Kaplan at the University of Chicago.

Speaker 1 I think they both did a great job illuminating a part of our economy that seems to prefer the shadows. I would love to hear what you think about the push to get retail investors into private equity.

Speaker 1 Our email is radio at freeconomics.com. We will be back next week.
Until then, take care of yourself. And if you can, someone else too.

Speaker 1 Freeconomics Radio is produced by Stitcher and Renbud Radio. You can find our entire archive on any podcast app, also at freeconomics.com, where we publish transcripts and show notes.

Speaker 1 This episode was produced by Teo Jacobs and edited by Gabriel Roth. It was mixed by Jasmine Klinger with help from Jeremy Johnston.

Speaker 1 The Freakonomics Radio Network staff also includes Augusta Chapman, Alina Coleman, Dalvin Abuaji, Eleanor Osborne, Ellen Frankman, Elsa Hernandez, Greg Ripon, Alaria Montenecourt, Morgan Levy, Sarah Lilly, and Zach Lipinski.

Speaker 1 Our theme song is Mr. Fortune by the Hitchhikers, and our composer is Luis Guerra.
As always, thanks for listening.

Speaker 2 The other half of my work was in deploying capital, so I helped advise on mergers and acquisitions.

Speaker 1 Sorry, just back up. It sounded like you said murders and acquisitions, which may have been a Freudian slip.
Oh,

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