E196: Professor Steve Kaplan: Do Privates Really Outperform the S&P 500?

Speaker 1 Why is Yale and Harvard getting out of private equity?

Speaker 2 That's a good question. I am not entirely sure, but I think it's a combination of things.
I think, first of all,

Speaker 2 they are, you know, Harvard and Yale both have some liquidity issues. They

Speaker 2 probably felt they were a little too illiquid. And so by selling some of their private equity portfolio, they get more liquidity.

Speaker 2 I would guess, too, they looked at their portfolio and they saw some funds that they

Speaker 2 were either not too happy with or were happy to get out of. And third, I think the bid-ass spreads, I imagine, in the secondary market were tight enough that selling

Speaker 2 they were able to sell it at what they thought were reasonable values. So I'd say those are probably the three things that have led to the sales.

Speaker 1 If Yale gave you a call, let's say Matt Mendelssohn, the CIO, gave you a call and said, how should I get liquidity in my portfolio? What would you advise me?

Speaker 2 Yale, I think,

Speaker 2 allocates too much to hedge funds. Hedge fund performance has not been great over time

Speaker 2 relative to other things. So first of all, I get to reduce my hedge fund exposure.

Speaker 2 I also would say the same thing about infrastructure and real estate. So I would take my allocations a little different from

Speaker 2 Yale in order to get some liquidity, and then I'd be

Speaker 1 go ahead. One of your research papers took a look at...
buyout, private equity returns between 2000 to 2017 and found that on average, buyout outperformed by 4% versus S ⁇ P 500.

Speaker 1 Tell me about that research and how did you go about ascertaining that performance?

Speaker 2 This is all ongoing, and I'm going to give you the most up-to-date numbers in a second. But the research started many, many years ago.

Speaker 2 No one really knew anything about private equity performance. And Antoinette and Shore, who's at MIT, and I wrote one of the first papers looking at private equity performance.
It was 2005.

Speaker 2 And we used data from venture economics, and we came up with a measure that is called the Kaplan-Shore public market equivalent that allows you to compare apples to apples, private equity, whether it's buyout and venture, with whatever index you choose.

Speaker 2 We chose the SP 500. It turned out the venture economics data were bad, and I'm going to come back to that later when we talk about LUDA.

Speaker 2 Since then, I've been using the Burgess now MSCI data, which are the absolute best data on private equity performance. They're much better now.
Burgess gets their data from limited partners,

Speaker 2 usually institutional, so it's pension funds, sovereign wealth funds, endowments. And

Speaker 2 because those data sources are LPs, there's not a selection bias.

Speaker 2 They're getting the data from the buyout funds, the venture funds, whatever it is, and Burgess takes the data, and then we have access to it.

Speaker 2 So, this is now very, you know, it's data that are as clean as you can get. They're still, you know, not perfect because you don't know everything that's out there, but this is the best data there is.

Speaker 2 And so, the most recent data, if you look at buyout funds

Speaker 2 in North America, from 2000 to 2019 vintages, and those are good vintages because you know, it's the data are through the Q1 of 2025.

Speaker 2 So the 2019 funds are at least five years old. And if you look at how those funds have done

Speaker 2 as of today, and the more recent funds, there's still some, you know, they're not fully realized. It could move a little bit because of

Speaker 2 net asset values, but they are currently running at 360 basis points above the SP 500 over that period. And or everything raised 2000 to 2019 as of 125 is 360 basis points over the SP 500, which is

Speaker 2 spectacular.

Speaker 2 And it's why so much money went into private equity. If you then you know compare it to the Russell 2000, which is maybe a better benchmark for

Speaker 2 private equip for buyout funds because

Speaker 2 they're not buying big companies, they're buying mid-cap.

Speaker 2 It's 460 basis points. So the performance has been very good.

Speaker 1 Private markets, because there's a lack of standardization and there's all sorts of biases. You mentioned one of these biases, LP-derived data from GP-derived data.

Speaker 1 There's also all sorts of marketing biases, standardization biases. It's actually incredibly valuable to have standardized data.
So you created this Kaplan Shore index.

Speaker 1 Tell me about what that index is and how did you normalize data from private equity to the SP 500?

Speaker 2 There are two ways to look at it. One is sort of cumulatively,

Speaker 2 which would be sort of like a market-adjusted multiple of the fund. So what it basically does is says, okay,

Speaker 2 if the private equity fund calls capital, let's say it

Speaker 2 calls $100 million,

Speaker 2 we put $100 million into the SP SP 500 that day.

Speaker 2 And then over the life of the fund,

Speaker 2 when the

Speaker 2 fund, when that money comes back, let's say we got a $300 million realization five years later,

Speaker 2 we compare that $300 million to what you would have returned

Speaker 2 if you put the $100 million in the SP 500. So if the SP 500 went from 100 to 200 over that period and you got 300, that's a PME of 1.5.

Speaker 2 You have beaten the S ⁇ P 500 by 50%.

Speaker 2 The S ⁇ P 500 went to 400, well, now it's 300 divided by 400. Your PME is 0.75.

Speaker 2 You have underperformed the S ⁇ P 500 by 25%.

Speaker 2 So the public market equivalent is basically saying apples to apples. You put your money in the S ⁇ P 500, you put it into the

Speaker 2 private equity. If it's greater than one, you've done better than the S ⁇ P 500.
And that number for private equity for those vintages I mentioned is 1.13. So it's 13%

Speaker 2 cumulatively better than the S ⁇ P 500. And the S ⁇ P 500 went up quite a bit over this period.
You can then annualize it.

Speaker 2 to something called a direct alpha where you're basically taking that 13% over the life of the fund and doing an IRR on the excess

Speaker 2 and that's the 360 basis points that I mentioned earlier. Something like 15% versus 11%

Speaker 2 would be a back of the envelope guess on that.

Speaker 1 When you look at this data, when you look at the data 2000 to 2019, how much roughly is the SP growing on a yearly basis versus buyout over 19 years?

Speaker 2 So I would say it's sort of 15 versus 11.

Speaker 2 So you would have done, and that's about the 400 basis points that I mentioned.

Speaker 1 So using the rule of 72, it's roughly doubling every five years versus doubling every six and a half years, which doesn't sound like a big difference, but it certainly compounds dramatically.

Speaker 2 It certainly compounds. 360 basis points a year is

Speaker 2 a big difference.

Speaker 1 Out of curiosity, do you also add dividends into the SP 500 as well?

Speaker 2 Yeah, so the SP 500, yeah, and that's you absolutely have to do that.

Speaker 2 So the S P 500 it is, includes dividends, which are, you know, roughly 2% a year, and the buyout fund performance would include all distributions.

Speaker 2 So it's really, it's an apples to apples comparison, which is why it's, and it's very simple, you know, to calculate, actually,

Speaker 2 which is why it's such a nice, you know, we thought it was a nice

Speaker 2 metric to use.

Speaker 1 One of your colleagues at Oxford, Ludo Filippo, is this private equity critic, just stating his bias.

Speaker 1 And he believes that a lot of these metrics are gamed, IRRs can't be eaten, and there's a lot of gamification from the private equity industry. Why is he wrong?

Speaker 2 He's wrong in that he is actually misleading on a number of things, and he's wrong on a number of things. And he's actually been wrong for quite some time.

Speaker 2 I'll say something nice about him later, that there's some things that he's right about.

Speaker 2 So these numbers that I gave you

Speaker 2 are based on cash flows. So

Speaker 2 these are not IRRs. These are not things you can't eat.
These are based on cash flows with the exception of the unrealized investments. that are still in the funds.

Speaker 2 2017, 2018, 2019 vintages, those aren't fully realized. So the numbers I gave you could move a little bit because

Speaker 2 we're basing what's left in the portfolio on the marks. But everything else is realized.
I mean, this is 2000 to 2015. These things are very realized, and those are the numbers.
And

Speaker 2 those have been the numbers. So, to say, some people say there's volatility, you know, people playing games with volatility, playing games with IRR, those numbers I gave you, those are quite real.

Speaker 2 So that's number one.

Speaker 2 To say they're not real is wrong. And Ludo doesn't say that.
The second thing that he's done on a number of occasions is not done in apples to oranges calculation.

Speaker 2 So what he'll do in a lot of these things is he'll put private credit, he'll put real assets

Speaker 2 in with the buyout and the venture, and then he'll compare them to the SP 500. Well,

Speaker 2 buyout and venture absolutely compare to the SP 500. Private credit, are you kidding? That shouldn't have an SP 500 type return.

Speaker 2 And then real assets and real estate and infrastructure, I think you can debate. But if you take out the

Speaker 2 private credit, the real assets, the infrastructure,

Speaker 2 these results are super strong through the 2019 vintages. So he sometimes mixes apples to oranges.
And in several of his things, he used the least favorable time periods to private equity.

Speaker 2 But if you use this long period, 2000 to 2019,

Speaker 2 what I just told you is what you get. So there's just no way to say buyout performance hasn't been very good through those vintages.

Speaker 2 Now, where he may turn out to be right, which is, you know, we'll see, are the more recent vintages. So, 2020 to 2022 vintages, which invested a lot of money in the craziness

Speaker 2 around the pandemic, where prices got very high.

Speaker 2 Those vintages right now have PMEs of about 0.98

Speaker 2 and the direct alpha of minus 1%

Speaker 2 versus the SP. So,

Speaker 2 they're coming in SP-like at the moment, and they could end up lower.

Speaker 2 What's interesting is they're still beating the Russell. So the Russell, they're beating the Russell by, like, the PME is 1.22, that means cumulatively 22% better, and an 8%

Speaker 2 annualized outperformance. So if you think the Russell is the right benchmark, you know, those vintages are going to be okay.
If you think it's the SP 500, maybe, maybe not.

Speaker 2 So maybe Ludo will be right. But what I'm doing and have done consistently is apples to apples, look at the time periods, be very clear about what you're looking at.
And

Speaker 2 that's what I've done. The other place where I think he's, again,

Speaker 2 I think I agree is real estate and...

Speaker 2 real assets have not performed so well and on an absolute basis and relative to the the SP and infrastructure probably not as well. So if I were

Speaker 2 advising an endowment, I would steer clear or not do very much of infrastructure or real estate and I would

Speaker 2 stick to what I think is real private equity.

Speaker 1 And you would advise that because real estate has worse performing returns.

Speaker 1 So even if it adds some more diversification, real estate and infrastructure on an expected value, you're actually lowering your returns. What about diversification?

Speaker 2 Diversification is the infrastructure. Infrastructure, I think, is the jury is out.

Speaker 2 The returns have been low. If you look at it relative to the S ⁇ P, the returns have been low.
If you look at it relative to

Speaker 2 some infrastructure index of public companies, it looks better. And so you kind of have to decide what you're doing with infrastructure.

Speaker 2 Are you looking for return or are you looking for diversification?

Speaker 2 The real estate even sort of underperforms the

Speaker 2 real public real estate indexes. So the real estate has really not been a great place in private equity.
I also, the other thing I think about is

Speaker 2 you're paying these fees, which are not trivial, whether it's 2 in 20 or

Speaker 2 1 in 10, depending on the asset class. And you're paying those fees

Speaker 2 because the PE firms are adding value.

Speaker 2 And so where are they going to add value? On the buyout side,

Speaker 2 they're doing it right. And a lot of these companies, the private equity funds, try to do it right.
they're adding real operational value to these companies.

Speaker 2 Infrastructure, I think it's a little harder, but you might be able to.

Speaker 2 Real estate, what are you doing? You're buying low, selling high.

Speaker 2 I'm not sure how you add value to

Speaker 2 a building over somebody else. So I think the value added is potentially much higher on the buyout and venture capital side.
So there's

Speaker 2 some hope

Speaker 2 or expectation that they'll earn their fees. I think it's harder in some of the other asset classes.

Speaker 1 When the capital insurer index is comparing buyout to SP 500, you're doing on a net basis. So what the LP would get, not what the private equity would get.
Absolutely.

Speaker 2 Yeah, and

Speaker 2 that's very important. It is all

Speaker 2 net of fees on the private equity side. And on the SP side, actually, we use the SP.

Speaker 2 So if you think there's a little bit of fee or a little bit of friction, we're kind of biased against the private equity by just using the SP 500.

Speaker 2 Although you can, you know, you buy an ETF, the fees are very low.

Speaker 1 I'm not some kind of private equity or venture apologist. I try to look at the market, although I have a bias.
I do think it performs better.

Speaker 1 It's good to see that the data shows that, but it seems to be the wrong way just because SP has had a five-year run, which if you really double-click on that, that's the Magnificent 7, you know, the Tesla, Microsoft, Apple, Meta.

Speaker 1 And maybe now they're slightly overperforming by 2%. Doesn't mean that it was a better decision at the time of investment.

Speaker 1 How far back does this data go, and how conclusive is it over a multi-decade timeline?

Speaker 2 You're absolutely right. And that's why the Russell is interesting, right? Because the SP has crushed the Russell.
And

Speaker 2 going back to

Speaker 2 Falapu and what also some other people say

Speaker 2 about private equity, they used to say in

Speaker 2 2005, 2010, oh,

Speaker 2 buyout investing, that's small cap value. If I just leverage small cap value in the public markets, I'd outperform.

Speaker 2 Well, small cap value has been terrible the last 15 years, and it's been crushed by the Russell.

Speaker 2 Russell value has been worse than Russell, which has been worse than SP 500. So you kind of have to think about what the right comparison is.

Speaker 2 And then I think you are getting diversification, which I think is your point. That when you invest over the long haul, there are going to be some periods where one asset class outperforms the other.

Speaker 2 And as long as they don't move exactly together, you should get, let's say, they have the same return, not a better return, but they're moving differently.

Speaker 2 By investing in more than one asset class, you're getting the same return with less risk. And so that's where, certainly, if you

Speaker 2 put a lot of money into buyout funds 2000 to 2019,

Speaker 2 you way outperformed even though over the entire period, even though you didn't outperform over every individual period, which goes to your next question going forward, what makes sense?

Speaker 2 That's where it's really,

Speaker 2 it's super hard because it's a lot easier to look backward than it is to predict the future.

Speaker 2 You have to come to some,

Speaker 2 I guess, expectation.

Speaker 2 What is

Speaker 2 this asset class going to do in terms of return relative to, say, the SP 500? Is it uncorrelated or not perfectly correlated?

Speaker 2 And then the right answer is if you think these asset classes have similar returns or private equity might be slightly higher,

Speaker 2 then you allocate to each of the asset classes, which is diversification.

Speaker 1 How much is SP correlated with buyout?

Speaker 2 This is sort of the shocker, or

Speaker 2 it's surprising,

Speaker 2 is

Speaker 2 they're not perfectly correlated. So you definitely get diversification benefit from holding buyout and the SP 500.

Speaker 2 And you can see that from what I just showed you. Buyout outperformed

Speaker 2 those vintages through 2019,

Speaker 2 and buyout is underperformed

Speaker 2 probably 2020 to 2021. So they're not moving in lockstep.

Speaker 2 And the returns have been higher on the buyout. So you get some higher returns and you get diversification benefit.

Speaker 2 The other question people ask, which is, I think, you know, is, is buyout just a leveraged you know, investment in the SP 500.

Speaker 2 And if it were a leveraged investment in the S P 500,

Speaker 2 you would see two things.

Speaker 2 Number one, you would see them move in lockstep, which you haven't seen them do. I just told you they didn't move in lockstep.
You would also see a beta

Speaker 2 well above one. And what a beta is, is how the returns on a private equity fund move with the returns on the SP 500.
So if

Speaker 2 they were,

Speaker 2 you were just, the buyout fund was just like the SP 500, the beta would be one.

Speaker 2 If it were a leveraged investment in the SP 500,

Speaker 2 and we think buyout firms probably have 50, 60% leverage, public companies 10, 20%, so that'd be like a 40% difference, you'd see a beta of 1.4

Speaker 2 or 1.5

Speaker 2 and you actually see betas of one

Speaker 2 when you estimate based on and this is based on cash flows not not marks

Speaker 2 so they have kind of the same

Speaker 2 risk as

Speaker 2 the S P 500. They don't move like the S P 500 and that gives you diversification benefits.

Speaker 1 Double click click for the audience, one of the most important things about Burgess and LP driven data, one is it's driven by LPs, so there's no survivorship bias and there's no GPs only sending data in when it's positive.

Speaker 1 The second one is this aspect of DPI. DPI is ground truth.
You could hem and haw for 20 years, say, I'm good, I'm bad. You could

Speaker 1 understate, overstate. The proof is in the pudding.
What dollars do you return back? That is an objective measure.

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Speaker 1 So that's what you're focused on, which I think is great.

Speaker 1 The marks themselves are very interesting. There seems to be a bias depending on vintage and manager, whether somebody would overmark or undermark their TVPI.

Speaker 1 On the overmarking, they want to go, they're going into fundraising cycle. They want to raise capital.
On the undermarking, it's just the rule of conservatism.

Speaker 1 You don't want a Yale endowment that gets a 1.75X mark in the next quarter, it's 1.7x. It just doesn't make you look good.
So, a lot of established managers don't like that.

Speaker 1 But I want to go into the data, not in terms of narratives or your personal views.

Speaker 1 What does the data say when it comes to whether private equity buyout and/or venture managers undermark or overmark as a general rule?

Speaker 1 And also, in which cases does the data show that one or the other happens?

Speaker 2 I've written two papers on this,

Speaker 2 at least. So,

Speaker 2 number one,

Speaker 2 historically,

Speaker 2 and this is before

Speaker 2 the 2021 period where they

Speaker 2 went

Speaker 2 into deals at high valuations. Historically, on average, they undermarked a little bit.
So, this is your point that they want to be a little conservative, right?

Speaker 2 And then the times when you do see them

Speaker 2 being a little more aggressive

Speaker 2 is when, as you said, when people are fundraising. And there are two things that go on when people fundraise.
People tend to fundraise

Speaker 2 when they're top quartile.

Speaker 2 So when do you fundraise? You have a great realization, something good happens, that's when you go.

Speaker 2 And if your fund is not doing well, you don't fundraise, you wait until it is doing well. So it's pretty amazing when you look at who raises funds.

Speaker 2 There are like very few bottom quartile or even third quartile funds. It's mainly top quartile and second quartile.

Speaker 2 And what that means is, you know, when you fundraise and you compare yourself to other funds that were raised at the same time as your previous fund, you know, you're ranked in quartiles by the Burgesses, the pitch books, the

Speaker 2 Cambridges, and people go when they look good relative to their

Speaker 2 comparison set. So

Speaker 2 people tend to go when they've had good performance, and then the poor performers tend to write their assets up a little bit around fundraising. So, and people are aware of this.
I mean,

Speaker 2 if you're an LP, you understand and you should be looking at the unrealized

Speaker 2 investments in the previous fund

Speaker 2 to to see the extent to which they're doing that. And I think LPs understand that.
So, the

Speaker 2 first two questions you said: what is the, you know, what do people do? They basically,

Speaker 2 as you said, the marks historically are a little conservative. They get less conservative when people are fundraising.
And

Speaker 2 that's

Speaker 2 what you see at the fund level.

Speaker 2 The people now saying that the marks, everything's overmarked,

Speaker 2 is probably

Speaker 2 comes from that 2021 period where they made a lot of investments at high valuations and they haven't fully written them down.

Speaker 2 So we'll see what happens going forward, how much of that turns out to be overmarked. And I think it's too early to tell, obviously, on the research, because you've got to wait and see

Speaker 2 what valuations those investments get sold at.

Speaker 1 A very famous manager, I no longer repeat his name because it's not the best quote attributed to him, but says that asset management is about having average return and great customer service.

Speaker 1 Now, clearly, it seems like it's people don't fundraise when they're in third and fourth quartile, but to what extent is that true?

Speaker 1 That if you have median returns and just great customer service and great LP management and maybe great transparency, whatever else you would group in that bucket.

Speaker 1 To what extent do you see funds that are able to do that continue to survive and thrive?

Speaker 2 I won't name names because

Speaker 2 I,

Speaker 2 well, I could, but I won't at least initially. Is if you look at the performance of the mega funds

Speaker 2 that were

Speaker 2 raised post-great financial crisis, vintages 2009 to 2019,

Speaker 2 and look at mega funds which are more than 10 billion dollars

Speaker 2 those funds actually their PMEs

Speaker 2 are

Speaker 2 lower than the average buyout PME and I think you know some of them have performed SP like

Speaker 2 and you know as a rules they're they're a little overall they're they're a little bit over the SP some of them are SP like

Speaker 2 and they still raise a a lot of money. So the mega funds, I think, are,

Speaker 2 as a class, in that bucket where their performance post-GFC has not been as good as the middle market folks,

Speaker 2 but they've continued to raise a lot of money, and they've delivered

Speaker 2 okay, overall

Speaker 2 somewhat better performance than the S ⁇ P 500, but not as good as some of of the others, but they give probably give good customer service. They also allow you to write big checks, so

Speaker 2 there's an economy of scale. And again, we'll see whether that continues over time as people say, gee, the returns here are less than the returns at some of my alternatives.

Speaker 1 You're a great researcher, and you don't like to speak off the cuff, but if I forced you to guess why LPs continue to invest into these funds, What would be the one or two factors that you think is driving LPs to invest in these mega funds that are underperforming SP 500?

Speaker 2 There's, I'm going to give a positive

Speaker 2 caveat to that.

Speaker 2 Even though the fund, let's say the fund is SP 500,

Speaker 2 they also get co-invest rights in a number of these funds, the larger investors. So, and on the co-invest, they're not paying fees.

Speaker 2 So, the blended, you know, SP 500 on the fund and better than SP 500 on the co-invest, they're beating the S P 500. So

Speaker 2 I think I'll

Speaker 2 pull that back a little bit, that the larger investors will beat the S P 500 less than they would have on sort of the smaller mid-market buyout funds. And I think that's probably the

Speaker 2 explanation.

Speaker 2 If you're a large investor, you know, big pension fund, big sovereign wealth fund, who do the co-invest, they're going into the mega funds because that's where they can put the money to work.

Speaker 2 That's not an irrational thing

Speaker 2 for the large investors. For somebody,

Speaker 2 I think for an endowment that's a $10 billion endowment, then maybe you want to go somewhere else. For the, you know, if you're a hundred billion, trillion dollar

Speaker 2 investor, then it makes perfect sense.

Speaker 1 Is there a back-of-the-napkin way to convert a 220 into a percentage, an annualized percentage?

Speaker 2 Yes, there is.

Speaker 2 You have to tell me what the gross return is to turn it into net, because that as the gross return gets bigger, the spread gets bigger. So take a 25% gross, which would be a very nice fund, right?

Speaker 2 25% gross is

Speaker 2 more or less

Speaker 2 3x gross.

Speaker 2 The

Speaker 2 3X gross,

Speaker 2 25% gross turns into like 19 net. So that'd be a

Speaker 1 6%.

Speaker 2 Yep, 6% fee.

Speaker 1 So absolutely. Said another way, if the fund is doing a 19% and you were accessing co-invest, let's say that you weren't adversely selected, you would be getting another 6%.

Speaker 1 Correct.

Speaker 1 So if you you were going apples to apples to SP 500 and you were even, now with a co-invest, you're 6%.

Speaker 1 And maybe if that's half of it, you're 3% if you have 12%.

Speaker 2 Correct. Correct.
And I think people say it's like co-invest like a quarter to 30%.

Speaker 2 So you take, you know, 30% of the 6%, be 1.8%. That would be

Speaker 2 sort of

Speaker 2 industry-wise.

Speaker 1 So one of these memes in the market is large buyout because there's no leverage is not as attractive.

Speaker 1 Maybe there's the same access to leverage, but the interest rates are higher, is almost inferior to SP 500.

Speaker 1 Small buyout, there's still like this operational value add that you could do, and you could have multiple expansion, all these things.

Speaker 1 I'm asking you to project into the future, which is not something you typically do, but to what extent do you believe in that meme? And what are your thoughts on this?

Speaker 2 You've got mega, you've got middle market, you have lower middle market on the buyout side.

Speaker 2 All of them,

Speaker 2 I think, have invested heavily in

Speaker 2 trying to add value to their companies. And I think that's the big change over

Speaker 2 when I started. So I started teaching private equity in 1996.

Speaker 2 And I would regularly have people in class, or I'd have GPs in class,

Speaker 2 and I would, I had a framework as to, you know, how I evaluate deals.

Speaker 2 And one of the pieces of the framework is

Speaker 2 how do you improve the business? And then another piece of the framework is, is what's your edge or what's proprietary about you doing the deal rather than somebody else?

Speaker 2 And

Speaker 2 I always, it was sort of bizarre. I like would

Speaker 2 ask them that, and then half the time

Speaker 2 they would say, Well, what are you talking about? I don't do that.

Speaker 2 About thinking about why, what's my edge, or why am I doing the deal? And I thought, gee, that's that's kind of weird. I would have thought of it, that's the first thing.

Speaker 2 Now, I ask that question, it's the first thing they think about. So, the world hugely changed.
That in 2000, that was a huge advantage if you did that.

Speaker 2 And I have some for several former students who did that and

Speaker 2 have very successful private equity funds. And now it's table stakes.
So everybody's doing it. So the world is more competitive across all the asset classes, but they're all doing it.

Speaker 2 So the good news is when they buy a company, they're buying it with an idea, here's how I'm going to make it better. Now the question is, can you make money? doing that because you're competing.

Speaker 2 And so you're competing against other funds who are doing this.

Speaker 2 So, that makes it harder to have excess returns. So, now let's look at the different parts of the market.
The mega funds,

Speaker 2 the hardest part for them these days is exiting because they have

Speaker 2 number one,

Speaker 2 it's hard to, if you've done a mega deal, it's hard to sell it to another private equity firm because the deal is too big.

Speaker 2 Strategics are tricky for antitrust reasons. So, even though

Speaker 2 the administration has changed, it's not clear that antitrust is going to be a lot less tough. It'll be less tough, but

Speaker 2 there's still

Speaker 2 antitrust risk. You can go public, but going public is harder these days.

Speaker 2 because there are fewer IPOs for whatever reason. And then once you do go public, it takes a long time to distribute because

Speaker 2 if you own 70, 80% of the company, it's hard to

Speaker 2 get all that out.

Speaker 2 And so, and then you've got continuation vehicles, which they're here because of the difficulties in exiting, but it's still for the mega funds, it's still their very, very big checks.

Speaker 2 So the mega funds, their real challenge is going to be figuring out how to exit deals. at decent valuations.
So I'm like, I'm a little nervous about the mega funds

Speaker 2 for that reason. The middle market, I think, is better because they can sell in, they can sell to other private equity, they can sell more easily into the continuation vehicles.

Speaker 2 The strategics, probably less antitrust, and IPO, probably less

Speaker 2 traditional. And then the lower middle market, I think, is still the most attractive because there's a little less competition for deals.

Speaker 2 I think you can do more with the companies and it's a lot easier to exit.

Speaker 2 The problem with lower middle market, it's hard to put a huge money to work because the funds are half a billion as opposed to $5 billion. So that's how I view looking forward.

Speaker 2 I would say that the other thing that's positive about buyout

Speaker 2 is that the buyout funds, the GPs are still underwriting to 20, 25% IRRs to 2.5%, three times gross.

Speaker 2 And so

Speaker 2 even if they don't,

Speaker 2 you know, they do the deal, they don't hit that number,

Speaker 2 the returns are still likely to be okay. So I like the risk return on buyout in general and, you know, skewed a little bit toward, you know, away from the megas.

Speaker 1 You've been teaching private equity since 1996. Obviously, you've had students and you're like, oh, I think he's going to be very successful.
And he was not successful.

Speaker 1 Maybe she was not supposed to be very successful. She was successful.
What characteristics do you find

Speaker 1 that in retrospect, what are some of the patterns that you find in retrospect among your students that are predictive of them being successful in private equity?

Speaker 2 How you do in my course is a very good predictor.

Speaker 2 And the reason, and I and I can tell you the people who have been very successful private equity investors,

Speaker 2 not exclusively, but with a high correlation, did well in my course. And I'll tell you why.

Speaker 2 Number one, you know, my course, it's a case course,

Speaker 2 you know, venture capital and buyout.

Speaker 2 And half your grade is class participation, half your grade is a final.

Speaker 2 So to do well on the final, there are really two pieces of the final usually.

Speaker 2 There's like an analytical numbers part, and then there's a big picture, like, do you you get the the economics the big picture to do really well on the final you got to see the big picture and you have to be able to do the numbers well those are pretty important to being a good investor right got to get the numbers right but you got to see the big picture then on the class participation To do well there, you have to

Speaker 2 have a couple of things. First, you have to be aggressive.
So you have to raise your hand and get out there.

Speaker 2 Second of all,

Speaker 2 you have to be articulate and be able to explain what you're thinking.

Speaker 2 And I think that is also very useful for private equity because you've got to be able to explain what you're doing to management teams. and to LPs.

Speaker 2 So if you have, you know, those characteristics, you're aggressive, you're articulate, you can do the numbers and see the big picture,

Speaker 2 those are four

Speaker 2 pretty good characteristics.

Speaker 1 When we last chatted, you mentioned that when people are scared to invest in private equity, it's the best time to invest

Speaker 1 outside of the obvious supply and demand dynamics. Tell me how that's actually...

Speaker 1 plays out in the market.

Speaker 2 I'm gonna caveat this, that

Speaker 2 it's hard to know

Speaker 2 when you're exactly at a peak. And I wrote a paper on this

Speaker 2 saying that at the time, you can't always tell.

Speaker 2 But when you are at a period like 2000 in venture, the amount of money in venture was crazy. That was not a good time to invest in venture.

Speaker 2 The vintages in buyout that have been sort of the mediocre performers, 06, 07, 08, those vintages are

Speaker 2 SP-like, slightly better. That's when a lot of money was going in.
And 2020, 21 as well, a lot of money went in. It was a big pickup.
And those vintages,

Speaker 2 as we saw, are not looking so great.

Speaker 2 And then

Speaker 2 on the venture side,

Speaker 2 you had people in 09

Speaker 2 saying the venture capital was dead. It's never going to go anywhere.
And those vintages were awesome, 09 to 2013 or 14 on venture.

Speaker 2 And

Speaker 2 buyout people thought was dead in 02 to 04. They thought it was dead in 2010 to 2014.

Speaker 2 So you have these periods where a lot of money is going in, and particularly after a couple of years when a lot of money has gone in, those are vintages that are historically not good.

Speaker 2 And then, on the flip side, vintages where there's not a lot of money going in have turned out to be good vintages. And as it, you know,

Speaker 2 that looks to me like supply and demand. And again, it's not perfect because venture,

Speaker 2 like in 97-98, was higher than it was in the previous years. And so, those vintages actually turned out to be very good.
But then the next couple of years was an amazing amount of money.

Speaker 2 Those were the bad vintages. So,

Speaker 2 it's not perfect because you can't always tell exactly where you are on the curve. And we're, by the way, at a period where

Speaker 2 You know, the buyout is actually down a little bit relative to the last few years.

Speaker 2 and ventures ventures down a little bit too so you know to your point I think earlier you know you had the 2021 stuff that was very people did deals they shouldn't have done there's this indigestion period we're kind of in a period where people are are

Speaker 2 being mixed or a little negative and that may continue if

Speaker 2 the the marks that we see if you know when they start selling they they

Speaker 2 those valuations come down a little bit so it'll be very interesting to see whether whether that's predictive or not

Speaker 1 it's easy to see when something's overheated and goes down because you see the withdrawal it's harder to predict when something's at the top until after because sometimes there's this bull run but to your point if something keeps on compounding by let's say a TAM of 20 30 percent for many years you could predict that maybe it won't go down next year it'll go down the next couple years although that's also difficult because Venture had this bull run from 2008 to 2021, essentially.

Speaker 2 If it were easy, if it were easy, you know, I'd be running a hedge fund. What I would do, you know,

Speaker 2 in this is

Speaker 2 rather than

Speaker 2 riding up and down, just sort of keep your allocations constant over time. I mean,

Speaker 2 that's the way to sort of, you'll put a little bit more to work in the

Speaker 2 bad year, in the low years, you'll put a little bit less to work in the overheated years.

Speaker 1 The analogy is: if you want to be top decile,

Speaker 1 you pick the bull in the bear markets, which you could argue it's possible or not possible. It's probably closer to impossible.
But if you want to be top quartile, you just stay in the market.

Speaker 1 You just keep on investing. And that's the investors that's done really well.

Speaker 1 One of the most absurd ideas to me on this private equity or venture capital is there seems to be this assumption that you have to to invest in a certain valuation.

Speaker 1 So if I'm investing in venture seed, it has to be at 20 million versus this much more real dynamic, which is supply and demand.

Speaker 1 So if venture is very unfavorable, you're investing at a lower valuation. So clearly at some valuation, it makes sense to invest in venture.

Speaker 1 So it's not a question of whether it's good to invest in venture or not. It's whether there's more good opportunities and capital that is chasing it at the time.

Speaker 1 In other words, it's not whether it's a good year, bad year to start a tech company. It's whether other people believe that and kind of the game theory between other investors in the market.

Speaker 2 Look, if you invest in the same deal at a 5 million valuation versus 50, your returns are going to be a lot different.

Speaker 1 I can't let you go without asking you about to normalize the data for venture against SP 500 over the last several decades based on LP data, not based on GP data.

Speaker 2 I didn't say something earlier that's well worth saying. There's some new research

Speaker 2 that uses data from Atapar.

Speaker 2 And Adipar basically is a platform for family offices and wealthy individuals who invest in a lot of funds. And what the Adipar data show

Speaker 2 is almost identical to the Burgess data. So the good news on that, there's two pieces of good news on that for your

Speaker 2 people listening: is number one,

Speaker 2 the Burgess data seem right. At a par, it's a different sample.
It's family offices, wealthy individuals.

Speaker 2 The returns that I just told you and will tell you are basically the same in Adipar and Burgess. That's one.

Speaker 2 Two, it seems like the family offices and wealthy individuals are getting into the same types of funds.

Speaker 2 So you're not adversely selected versus the institutions, what the family offices offices and wealthy individuals get into. So, if you're going to do this,

Speaker 2 that's good news. Venture is much more variable

Speaker 2 than

Speaker 2 the

Speaker 2 buyout side. So, venture has had periods where

Speaker 2 it's well outperformed the SP 500, and it's had periods where it hasn't. And so, if you look at, for example,

Speaker 2 2009 to 2017 vintages,

Speaker 2 Venture did

Speaker 2 spectacularly.

Speaker 2 The average PME is like 1.25, 1.3 versus the 1.15

Speaker 2 or so for buyout. On the other hand, 2020 to 22 vintages,

Speaker 2 they're they're underperforming the SP 500 by quite a bit. The PMEs are about 0.8 or 20%

Speaker 2 worse than the SP 500. And

Speaker 2 of course, you had the mid to late 90s, the venture was amazing because of the dot-com boom. And then you had 99 to 2006, where performance was terrible because of the dot-com bust.

Speaker 2 So venture is much more variable by vintage year than buyout's been. Buyout's been very consistent.

Speaker 2 It's still over time beaten the SP 500, but a lot more variation.

Speaker 2 And then the other thing that's a that's a question mark with venture, at least among the academics, is that the beta of venture funds is a good deal greater than one.

Speaker 2 So you have to decide if you're an investor, you know, do you care? Like some people will say

Speaker 2 if you think that the beta is a lot bigger than one, and then you

Speaker 2 compare

Speaker 2 that return

Speaker 2 to

Speaker 2 venture, then

Speaker 2 the PME adjusted for the beta actually doesn't look so good. On the other hand, if you're just, if you say, okay, I...
I'm just comparing it to the S ⁇ P 500, that's my benchmark, then it looks good.

Speaker 2 So I think that's a venture is a trickier asset class in that regard than buyout.

Speaker 2 I would add, funny enough, venture, I think, does give you some diversification benefit because it performs well at different periods. Like I just said, venture didn't perform very well 2020 to 25.

Speaker 2 The SP went up. And so venture has, you know, does perform differently from the SP 500.

Speaker 1 And that's the entire venture asset class. So that is the mean return for venture.

Speaker 2 That's mean. And so you also have to be careful on venture in that mean

Speaker 2 is not median. And so

Speaker 2 median is lower. So there's a skew.
In buyout, the mean and median are pretty close. So in buyout, it's sort of you that the outliers,

Speaker 2 you know, it's more of a normal distribution. Let's say venture,

Speaker 2 this is the getting into the top funds

Speaker 2 matters. And

Speaker 2 the top funds are more predictable in venture.

Speaker 2 Buyout, it's very hard to predict who's going to be the top fund at any vintage year.

Speaker 2 Venture, it's, you know, the

Speaker 2 founders funds, the sequoias, the benchmarks have been consistent. And so venture, you know, you have to make sure you're getting access.
Now, that's the bad news.

Speaker 2 The The good news is the Adipar data,

Speaker 2 the returns are similar, which suggests that people do get into some of the good funds.

Speaker 1 There's like a 52% persistence in venture. I believe that's a University of Chicago study, actually.

Speaker 2 That would have been my study.

Speaker 1 So, to quote you back to yourself,

Speaker 1 52% of funds raised post-2000 had above-median performance,

Speaker 1 some persistence, 32%

Speaker 1 at top quartile performance. So 32%

Speaker 1 persistence,

Speaker 1 52% outperformance post-2015. Well, Steve, there's a lot more to unpack, but we'll have to leave it to another podcast.
I appreciate you jumping on and sharing your wisdom.

Speaker 2 Great. It was a pleasure.

Speaker 1 Thank you. Thanks for listening to my conversation.
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