Dan Rasmussen - Private Equity Returns in Public Markets - [Invest Like the Best, EP.78]

Episode Summary

Executive Summary: Patrick O’Shaughnessy interviews Dan Rasmussen about private equity’s historical outperformance, why it has likely faded, and how Verdad translates those lessons into a global public-equity strategy focused on small, cheap, levered firms. The episode also critiques common finance frameworks like Porter's Five Forces and emphasizes forecasting discipline, base rates, and empiricism.

Main Topics: Private equity’s changing edge (Priority: 5/5): Rasmussen argues PE worked when it bought cheap, levered small businesses, but crowding has erased the edge. Operational-improvement myth (Priority: 5/5): He says most PE returns came from leverage, not broad operating skill; cost cutting is the real exception. Valuation and leverage (Priority: 5/5): Purchase price and debt levels drive outcomes more than narrative, making expensive LBOs fragile. From PE to public markets (Priority: 5/5): Verdad applies PE-like factors to public stocks, targeting small, cheap, levered companies with deleveraging. Forecasting and base rates (Priority: 4/5): Rasmussen rejects expert intuition in favor of base rates, empirical testing, and live validation. Japan as a special case (Priority: 4/5): Japan offers a large universe, low valuations, and lower bankruptcy risk for leveraged value strategies. Skepticism toward Five Forces (Priority: 4/5): He argues Porter’s framework lacks empirical support and can mislead investors toward glamour stocks.

Key Arguments: PE outperformed when buying <7x EBITDA, but those opportunities are now crowded and pricier. Most PE firms mainly change capital structure; operating improvements are weak in aggregate. Revenue and EBITDA growth slowed post-acquisition in his sample of ~390 debt-financed deals. Leverage rose sharply in 70% of cases, from about 2x debt/EBITDA to 4-5x. Higher purchase prices reduce equity returns by lowering cash flow yield and raising interest costs. 3G is an exception where EBITDA margins often doubled, showing selective operational skill. Verdad’s strategy is small, cheap, highly levered equities, filtered for bankruptcy risk. Deleveraging is both important and knowable; past debt paydown predicts future paydown better than chance. Japan reduces bankruptcy risk, making levered small-value investing less volatile there. Porter-style industry structure explanations are unsupported; market share rarely predicts profits.

Data Points: Private equity excess returns (1980-2010): about 6% in excess of the public market - Rasmussen cites Cambridge Associates-era PE outperformance before crowding intensified. Private equity performance since 2010: underperformed since 2010 - He says recent benchmarks no longer support the historic return narrative. Private equity capital to deploy: $700 billion - Mentioned as committed capital yet to be deployed into PE funds. Sample size of PE deals studied: about 390 private equity deals - Deals that issued public debt and disclosed GAAP financials pre/post acquisition. Pre/post acquisition window: three years pre-acquisition and three years post-acquisition - Used to test operating changes around buyouts. Debt/EBITDA before acquisition: about two times debt to EBITDA - Average pre-buyout leverage in the empirical sample. Debt/EBITDA after acquisition: four or even five times debt to EBITDA - Typical post-buyout leverage increase found in the data. Cases with massive increase in debt: 70% - Share of cases where leverage jumped materially after acquisition. PE purchase multiples now: 11, 12 times EBITDA - Current deal environment described as highly competitive and expensive. Historical cheap LBO pricing: less than seven times EBITDA - Described as the valuation range that made PE returns attractive. Institutional belief about PE alpha: 50% - Share of institutional investors who expect PE to outperform by 4% per year. Institutional belief in parity: less than 10% - Share who think PE will merely match public markets. Forecasting sample: 30,000 forecasts - Tetlock study referenced on expert forecasting performance. Japan listed companies: 3,500 publicly listed companies - Shows the size of the Japanese opportunity set for Verdad. US market breadth comparison: 3,000 - Approximate number of U.S. equities contrasted with Japan and global universes. Global fund allocation to the US: about 40% - Verdad’s global fund still keeps substantial U.S. exposure. Global fund allocation to Japan: about 35% - Japan is described as a core opportunity set for the strategy. Historical volatility of Japan strategy: 17% standard deviation - Rasmussen says the Japan version was much less volatile than expected. Lock-up period: three years - Verdad only accepts locked-up capital to align investors with its time horizon.

Pivotal Quotes: "Private equity is a really fascinating world, and I think it's an asset class that very few people understand." — Dan Rasmussen: He opens by framing PE as widely misunderstood despite its reputation. "Anything where there's consensus is unlikely to provide a good investment opportunity." — Dan Rasmussen: He explains why contrarian, non-consensus reference classes matter. "I think the Hippocratic oath of investing, to some extent, is, you know, don't lose people money." — Dan Rasmussen: He describes the role of time horizon and investor alignment.

Implications: Investors should treat private markets, factor strategies, and strategy frameworks as testable hypotheses; the unresolved question is how long crowded valuation regimes can persist.