This week is the 10th anniversary of the collapse of Lehman Brothers, a flash point in the financial crisis. The economy has rebounded since then and the stock market has risen to record highs, but a feeling of caution looms over many investors.
One of them is Dan Rasmussen, a contrarian investor who has marshaled data and historical returns to argue that three of the most popular asset classes for high-net-worth investors are not as desirable as they seem.
Mr. Rasmussen, founding partner of Verdad Capital in Boston, has written an article and two reports that make a case against investments in private equity, venture capital and private real estate, and he has piles of data to back up his argument.
“I want to give the advisers the intellectual ammunition to allow them to say, ‘No, I’m not going to put money into these strategies,’” he said.
But some advisers challenge this point of view, saying it is almost akin to market timing. “You could look at any asset class at any point in time and position it in a way and understand why it’s outperformed or underperformed,” said Scott Stackman, managing director of private wealth at UBS Wealth Management.
Here is Mr. Rasmussen’s argument for caution in three areas:
A model past its prime
During the financial crisis, Mr. Rasmussen worked at Bain Capital, a leading name in private equity. One of his jobs was to collect data on deals by Bain and its competitors to determine why some had done well and others had not.
The more profitable deals were the least expensive ones, he found. The cheapest 25 percent of deals accounted for 60 percent of the funds’ profits. The top 50 percent accounted for just 7 percent of profits. The difference was the price paid for the company. This was not solely for the obvious reason that paying less is better, but because private equity funds typically borrow 60 percent of the purchase price, which affects a company’s profitability.
Mr. Rasmussen said he admired the success Bain had in the 1980s and ’90s, but began to question whether the private equity model it had helped pioneer was still sustainable.
When early private equity firms bought relatively small companies at a discount and loaded them up with debt, the amount of leverage on the company was still about four times the company’s earnings before interest, taxes, depreciation and amortization, a measure of profitability known as Ebitda.
Private equity firms continued to apply this strategy, but they were paying more for the companies, and consequently the amount of debt was rising to more than six or seven times Ebitda. With leverage at 10 times Ebitda, Mr. Rasmussen found, a company’s free cash was almost all going toward debt service, and it was nearly impossible to be profitable.
A recent example is Toys “R” Us, which Bain, KKR and Vornado Realty Trust acquired for $6.6 billion in 2005. When it filed for bankruptcy in 2017, the toy company said it had $5.3 billion in debt and was paying $400 million in annual debt service payments.
Mr. Rasmussen said the sector would look worse if not for a few high-performing funds that pulled up overall returns.
“It’s probably the worst time ever to invest in private equity,” he said. “And now, it’s being packaged for wealth management firms and registered investment advisers.”
According to PitchBook Benchmarks, which gathers data on private equity investments, only 25 percent of funds have been outperforming the market, and have done so by a smaller amount.
Mr. Stackman of UBS said he was still putting money into private equity and hedge funds for certain clients, and reducing their investments in public equities or fixed income.
“I don’t know if I’d term it as a true shift,” he said. “This is our belief in how the high-net-worth clients could and should be invested.”
Mr. Rasmussen said the funds that still provided high returns equal with the risk were generally smaller ones that acted more like the owners of the companies they bought and didn’t just add debt to increase returns.
At his own firm, Mr. Rasmussen said, he modeled the strategy on what private equity funds were doing in the 1980s and 1990s: buying smaller companies at cheap prices and putting a reasonable amount of debt on them. In Verdad’s case, Mr. Rasmussen focused on buying publicly traded companies with a small market capitalization.
Verdad’s main leveraged company fund lagged its small-cap benchmark in the first two quarters of this year but kept pace with a broader global benchmark. Over the past three years, the strategy has beaten both the small-cap and global benchmarks by 6 percentage points.
An inconsistent pattern
The argument against venture capital is less nuanced. Top private equity funds are still delivering high returns, but venture capital funds have largely functioned as what Mr. Rasmussen calls “a rich man’s lottery.”
He cites data from Cambridge Associates showing that venture capital has underperformed the Standard & Poor’s 500-stock index, the Russell 2000 Index and the Nasdaq over the last 15 years. And he argues that those venture capital firms that built big names often did so with a few spectacular investments that overshadowed more mediocre ones.
The venture capital firm Benchmark, for example, invested $6.7 million in eBay in 1997. That investment grew to $5 billion in two years, outshining other investments.
Any venture capitalist will argue that the big winners make up for all the bets that did not pay off. Mr. Rasmussen does not dispute that; he emphasizes how difficult it is to find those funds that are going to consistently make the big winning investments.
Higher fees mean lower returns
Mr. Rasmussen draws a distinction between real estate owned by private equity firms and real estate investment trusts. And for him, the difference in returns comes down to fees. A REIT typically charges a management fee of less than 1 percent. A fund that owns real estate will charge a typical private equity fee, which can be as high as 2 percent to manage the money and 20 percent of the profits.
“By and large, it’s a pretty efficient asset class, since rental income is a fixed contract,” he said. So fees play a big role in the difference in returns.
But real estate owned in REITs, he said, could be a good buffer for anxious investors because they have a low correlation to traditional equities given their stream of rental income. They’re also less risky, he wrote, than his focus, small-cap stocks.
Excluding entire asset classes can be a tough sell, some financial advisers say. Investors should be asking instead whether an asset class is performing as it should.
“You could put together a low-volatility portfolio of hedge funds, and they will get very consistent return,” Mr. Stackman of UBS said. “But you’re not getting the generous returns the S. & P. has been giving you since 2009.”
That would be around 2 percent a year for hedge funds versus about 18 percent for the S. & P. 500. And many asset classes now have had a good run.
There’s another cautionary argument on private investments. Because they are inherently risky, they should be undertaken only by the most experienced investors.
Michael W. Sonnenfeldt, founder and chairman of Tiger 21, an investment club for people with $10 million to $1 billion, said the group’s 630 members had increased their investments in private equity and real estate.
The group’s collective portfolio has about 50 percent allocated to private equity and real estate. Public equity and debt make up just 35 percent.
Mr. Sonnenfeldt said that such high allocations to risky private assets were a product of how Tiger 21’s members often made their fortunes, building businesses and taking risk.
But he agreed with Mr. Rasmussen’s argument on investing in smaller companies.
“What our members do is not a referendum on the entire market,” Mr. Sonnenfeldt said. “It’s our members. Most people who are thinking about these investments wouldn’t do well without the skills to be successful. That’s an important distinction.”
And he said the group’s members expressed interest in private asset classes because, they said, their experience allowed them to influence the management of the investment.
“Our members overwhelmingly express their interest in private equity through ownership of a company or investment in a company,” he said. “Only a third have put money into a fund, and then they’re biased toward the smaller funds over the larger ones, for the reasons Rasmussen is talking about.”
In other words, the message is a resounding caveat emptor.