Small Cap's Big Secret: A Conversation With A Private Equity Fund Manager, Part 1

Image courtesy of Verdad Fund Advisers.

Dan Rasmussen is a graduate of Stanford Business School, a former analyst with Bain Capital, the New York Times Bestselling author of "American Uprising: The Untold Story of America's Largest Slave Revolt," and the founder of the investment management firm Verdad Fund Advisers. In 2017, Rasmussen was named to the Forbes 30 Under 30 list.

However, Rasmussen might be best known for his analysis on private equity investment, which serves as the basis of Verdad's fund portfolio strategy.

Marketfy Maven Tim Melvin recently had the opportunity to speak with Rasmussen about the business and market patterns that inform his private equity investment strategy. Below is part one of their conversation, edited for length and clarity.

Tim Melvin: We are on this morning with Dan Rasmussen of Verdad Capital currently located out in the Seattle, Washington area. We had uncovered his work before because he did a study a few years back that looked at replicating private equity and had some pretty dramatic results. So Dan, thanks for spending some time with us this morning.

Dan Rasmussen: It is my pleasure, Tim. It is nice to speak to you and your audience. 

Melvin: You were working for Bain Capital after college and they put you to work analyzing where our private equity returns came from and you found some surprising things. Can you talk a little bit about that what you found? 

Rasmussen: The first thing to note is that private equity has been one of the only asset classes to dramatically outperform the public stock market over long periods of time. Private equity has returned about say 15 percent per year over the past 25 years relative to about 7 or 8 percent for the public market. Public equity investors would do well to study what really is it about private equity that is causing it to make these excess returns. So we had a unique angle into this at Bain Capital because we had access to a massive amount of proprietary data on the industry. So let us start there.

There are a few things that differentiate a private equity investment from standard S&P 500 company. The first is size. Your average private equity deal is about $200 million of equity or market cap relative to over $30 billion in S&P 500, so we are talking two orders of magnitude smaller. The second is that private equity deals are about 60 percent leveraged on a net debt to enterprise value basis versus about 3 percent in S&P 500, so much more levered. Then third, and this is sort of the core of my thesis, is about valuation. In the 1980s and 1990s private equity buyers were paying about half the multiple of the S&P 500 for the companies they bought. In the 2000s it went up to about 25 percent discount and in the late 2000s and early 2010s private equity firms pain equal to or more than the S&P 500. What we found in our research with the returns in private equity came very disproportionately from the cheapest of the small levered companies the more expensive one really did not work out well.

Melvin: The multiples have clearly gone a lot higher and it is dragging on the returns. It is also one of the reasons you are seeing so much cash pile up in some of the larger shops. Would you take that as a statement of overall market valuation, the fact that multiples are so high right now?

Rasmussen: I think it is two things. The first is that private equity became an asset class only recently, and once it became an asset class money started pouring in and people were looking at historic returns of private equity and thinking they were going to get the historic returns of private equity in the future. I think in doing so they misunderstood what had made private so successful, which is that the private equity guys were innovators. They were finding a pocket of the market that was much cheaper than the broader market and they were using financial engineering, taking out debt to really choose their returns. So you have the twin problems of both.

Look, the entire market is to some extent pricey. But private equity in particular is overpriced because private equity investors do not necessarily understand what they are getting. They said, "Well private equity, not only has it produced these great returns but it has not been particularly volatile, so what a great strategy, we'll put all our money in here." They do not realize what they are actually buying is levered micro caps, and levered micro caps are very volatile. But the private equity firms, because they are private, can mark them and say it is not volatile. It is this set of misconceptions that I think are driving too much money into private equity and inflating the prices even beyond general appreciation of the market.

Melvin: I am a lot older than you, so it is something I have seen over the years.  Anytime something gets too much money, I call it almost the Berkshire Hathaway effect, all of a sudden the size of the deal that you can look at just swells enormously and that I think eliminates a lot of the returns. 

Rasmussen: I think you know, as a value investors and students of the market, places where money is flowing in are often . . . you have got to be extremely cautious. If everybody agrees that something is a good thing it is usually a bad thing. That is the sort of game that investors play. We are betting against expectations. Private equity is something where sort of seems like you are getting money for nothing, you are getting higher returns with less risk, while the reality is that when you are paying on average 11 or 12 times EBITDA, putting 6 or 7 turns of debt on these tiny little businesses, that is not a recipe for success. It is a recipe for way too much risk and subpar returns, so private equity investors, unfortunately, are going to have to learn that the hard way.

Melvin: In some of the research that I've read, you like to pay around 6 times or less EBITDA for the companies that you invest in. Is that correct? 

Rasmussen: That is right. Our portfolio is at about 5 and ½ times. 

Melvin: In addition to buying cheap, you found one other major component that drove these excess returns was debt pay down. Can you talk a little bit about that?

Rasmussen: My portfolio has a free cashflow yield of about 23 percent, and that is basically cash for financing divided by market capitalization. That is a truly remarkable number.

If you think about a dividend yield investor who said, "Well, I have got a portfolio of dividend yield stocks and the dividend yield of my portfolio is 23 percent," you would know that something was wrong. It is just too good to be true. But that is not the case in the levered equities, right, because people do not necessarily see the yield because it is all going to debt paydown. It's not going to dividends or buybacks. Equity investors who are not used to dealing with levered capital structures do not see that money and they do not understand that yield. 

What we observed is that this deleveraging process. Buying companies that have historically been paying down debt is a great idea because as they continue to pay down debt, a bunch of virtuous things happen. First, you reduce debt, reduce interest payments, the entire net income. It also means less risk of bankruptcy. Traditional value investors do not like levered companies, so the less levered you get, the larger a base of investors are willing to look at the name. So for these companies that delever, you just have this virtuous flywheel. 

Melvin: You actually did a formal study of this approach with Brian Chingono from the University of Chicago a few years back.  What did the more formal academic study find? 

Rasmussen: So Brian and I worked with professors at Stanford and Chicago to help us look at and do sort of a complete academic study. We looked back to 1964 in the U.S. and we looked at how the strategy would have done. The answer is that it would have returned about 23 percent a year, which is very similar to the gross returns of private equity over that time period. The only drawback is that it is very volatile. Specifically if you think about all of these companies or issuers generally of junk bonds or high yield debt.

What we saw in our longer term back-test is that you get these great returns, but every 3 or 5 years there is a credit crisis and the high yield bond markets sells off and all these levered companies have a lot of refinancing risk. So you see big drawdowns in this type of portfolio every 3 to 5 years from the credit cycle and it would bounce back very quickly. So you can think about the strategy as essentially a play on the debt cycles and on the high yield bond market where you earn a very high excess return in exchange for taking some level of credit risk. 

Melvin:  The credit cycle is not that mysterious. You can tell when it is getting a little long in the tooth. Is there any benefit to a timing oriented approach around the credit cycle with this stuff?

Rasmussen: You know, it is something I have been studying and I have been trying to figure out. I think it is difficult.  Obviously you could do it. It would be amazing. I have not come to sort of a silver bullet yet, but hopefully I will find one as I do more research. 

Melvin: That is one advantage I guess that the private equity funds kind of have. They do not have to take the market to market volatility. They can just determine pretty much for themselves what a company is worth. Does the volatility bother you at all?

Rasmussen: I say, look, in order to make money long term in the markets, you have to take advantage of some mispricing. I think that the great advantage of this strategy is we are taking advantage of mispricing that always has existed and always will exist, which is the behavioral bias of other investors. They are afraid of volatility and they run away from it, and thus, all the worst behavioral biases that Kahneman and Tversky wrote about are exacerbated in my part of the world. So for me, I love volatility because it allows me to more efficiently take advantage of other people’s behavioral biases. 

To read part two of Tim Melvin's interview with Dan Rasmussen, where they discuss the upside of volatility and the metrics of private equity investment, click here.