An email from AA:
This was long due. Just want to thank you for every issue you put together. Your articles are truly classy, informative, and a catalyst to my performance at work and home. No frills and fancies, Just plain thinking and clear speaking…. In this age of fast information and faster dissipation, your [writing] truly stands out.
Is it possible to refine one’s sensibilities to such a point that one is no longer a happy consumer of puerile humor? Or is it just impossible for me?
The Bizarre Rationale Behind Private Equity Funds
Vanguard, that folksy company that has so successfully catered to middle-income investors for most of my adult life, is opening a private equity fund.
It’s part of an attempt to “broaden the company’s appeal… to larger investors,” a company spokesperson said.
I understand why they would want to do that. What I don’t understand is why anyone would want to invest in it.
My objection is not about Vanguard but about the asset itself.
A private equity fund is like a mutual fund. But instead of owning stocks, it buys shares of private businesses, including start-ups. When a new business succeeds, there is often a period when their growth is extreme – 100%, 200%, even more in a single year. Link several such years together and you could, in theory, dramatically multiply your money.
So that’s the allure.
What’s the reality? I’ll get to that in a moment. First, let’s talk about fees.
The average actively managed equity fund (your bread-and-butter mutual fund) charges about 1% a year in management fees. That’s $1000 in annual fees for a $100,000 account.
You can pay considerably less than that by investing in an index fund. An index fund is basically a basket of stocks meant to track the ups and downs of the stock market. It’s not actively managed, so the fees are considerably lower. It’s possible to find index funds with an expense ratio of 0.1%. That’s only $100 in fees on a $100,000 account.
Private equity funds typically charge a yearly management fee of 2%, plus an incentive fee of 20% of the profits.
That $2000 in management fees for a $100,000 account plus $200 on every $1000 of profits.
Let’s look at how these expense ratios work out under different scenarios…
Scenario One
In year one, the portfolio appreciates 10% – from $100,000 to $110,000.
In an index fund, your fee would be one-tenth of 1% or $110. You’d be left with $109,890.
In an actively traded mutual fund with a 0.1% expense ratio, your fee would be $1100. You’d be left with $108,900.
And in a private equity fund, you’d pay $2000 for the management fee and another $2000 based on 20% of the $10,000 profit. You’d be left with only $106,000.
Now you might think that the $3000 difference between an actively managed mutual fund and an actively managed private equity fund is a small price to pay for the “privilege” of being able to invest in private start-ups. But before you come to that conclusion, consider how this “mere” 3% difference adds up over a career of investing.
Scenario Two: A Longer View
The historic return on the market for the past 100 years has been roughly 9% to 11%. Let’s use 10% to make the arithmetic easier.
A hundred grand appreciating at an average of 10% over 40 years will become about $4.5 million.
In an index fund with a 0.01% fee, you’d keep about $4.4 million of that, paying out about $100,000 in fees over 40 years.
In a “regular” actively managed equity mutual fund with an expense ratio of 1%, you’d end up with only $3.1 million. Which means you’ve paid the fund managers $1.3 million in fees.
And in a private equity fund where you’re paying a yearly fee of 2% and 20% on profits, you’d have, at the end of 40 years, something like $1.6 million. Meanwhile, the fund has collected $3 million in fees!
So why would anyone want to invest in a private equity fund?
There’s only one logical answer: Because they expect the fund to exceed what they could get elsewhere. And exceed it by at least 5%.
So, back to that $100,000 over 40 years…
Let’s say that instead of producing the historic average return of 10% a year, the private equity fund got you twice that – 20%, or 16% after all fees and expenses. Then, instead of making the $4.5 million you could have made on an index fund averaging 10%, you’d be left with something like $37 million.
Again, that’s the allure of private equity for investors.
What are the chances of getting those sorts of ROIs over any length of time?
Next to zero.
Private businesses, when they are successful, often double and triple their value over a period of 3 to 4 years. Some of them continue to grow at 20% to 30% for several more years, and again at about 10% for another 5 to 10 years, before settling at 2% to 5%.
If you get enough of these sorts of companies in one basket, you can experience phenomenal results. But it very rarely happens.
There certainly are some private equity funds that do well. But like mutual funds, they are the exceptions. According to Oliver Gottschalg and Ludovic Phalippou, writing in a recent issue of theHarvard Business Review,“PE funds have historically underperformed broad public market indexes by about 3% per year on average.”
So, again, why are people interested in them?
I can think of three possible answers.
As noted in the HBR article: “Private equity returns are often reported as the internal rate of return (IRR) – the annual yield on an investment – of the underlying cash flows.
“This implicitly assumes that cash proceeds have been reinvested at the IRR over the entire investment period – that if, for example, a PE fund reports a 50% IRR and has returned cash early in its life, the cash was put to work again at a 50% annual return. In reality, investors are unlikely to find such an investment opportunity every time cash is distributed.”
This distorts results immensely. It allows PE funds to project triple-digit returns when the reality is much, much less. For example, the “top performing PE fund in one study showed a yearly profit of an astonishing 464% per year. But when the same projections were run using a still optimistic 12% ROI for those gaps, the yearly ROI dropped to 31%.”
A $65,000 Richard Mille watch doesn’t work any better than a $35 Seiko, but it sure buys you a lot more prestige. Private equity funds are prestige products for ostentatious rich people.
And the fact that private equity funds are exclusive – that only “qualified” investors are allowed to invest in them – adds to the prestige. (A “qualified” investor, commonly referred to as an accredited investor, is an individual/entity that is legally permitted by the SEC to invest in hedge funds, venture capital funds, private equity offerings, and other private placements. These investors need to demonstrate a sufficient income or net worth before they are allowed to purchase unregistered securities.)
Now here’s something you may not know about rich people as investors. Although they aren’t any smarter than non-rich people, they think they are.
Having big houses and lots of money in the bank, they begin to believe what others believe about them – that they have a better understanding of business, economics, finance, and investing than the average person.
But they don’t.
And since they don’t know much about any of those things – and because they are too lazy to figure it out themselves – they prefer to invest their money in funds.
And, finally, because they are arrogant, they are drawn into the allure of private equity funds. Private equity funds understand that and cater to it.
You probably know that Valentine’s Day commemorates the death of St. Valentine, who was executed by Emperor Claudius II on February 14 sometime in the 3rd century. But you probably don’t know why he was sentenced to death. According to ReadersDigest.com, “the most popular [legend] says he was a priest who married young couples after Claudius outlawed marriage for young men. (Apparently, they were better soldiers when they weren’t romantically attached.) Another says he helped save Catholics who were imprisoned for their religious beliefs.
“However, the holiday may have been promoted to overshadow the pagan festival Lupercalia. Between February 13 and 15, Romans celebrated by sacrificing a goat and a dog and whipping women with their hides. Crude as it may seem, people believed this made women more fertile, and women actually lined up to get slapped with bloody hides. In the 5th century, Pope Gelasius I outlawed Lupercalia and officially declared February 14 Valentine’s Day.”
“All you need is love. But a little chocolate now and then doesn’t hurt.” – Charles M. Schulz
coup de foudre (noun)
Coup de foudre (koo duh FOO-druh), a French expression, literally means thunderbolt. It is often used to describe a sudden unforeseen event – in particular, love at first sight. As used by Susan Choi in My Education: “Coup de foudre; perhaps it was real. One went from believing, when twenty, that it was the kind of love that was real, to believing, once closer to forty, that it was not only fragile but false – the inferior, infantile, doomed love of twenty-year-olds.”
Is this even legal today?
“Human energy is a limited resource. It’s better spent laser-like on important things you can change than diffused on unimportant things you cannot.”
– Michael Masterson
Idea for a New Book
What Do You Think?
I’ve dug myself into another hole of hyper-ambitious goal setting. I’m in the middle of writing 28 books.
That’s not an exaggeration.
And now Lindsey, my partner in a business that will be publishing a few of those books, has suggested that I might want to write yet another one – a 29thbook!
Longtime readers of this blog will have noticed that I’ve been publishing drafts of chapters for one of those 28 books – a project tentatively titled Principles of Wealth. (I posted the most recent one hereon Monday.)
Lindsey’s idea is that I should write a book like Principles of Wealthbut about business – the most important, universal discoveries I’ve made about starting and growing successful businesses over the past 40 years.
At first, I was horrified. I’m already pushing myself to finish the 28 I’m working on now. Why take on a 29th?
But Lindsey pointed out that, in our archives, we have literally thousands of essays I’ve written about entrepreneurship, marketing, business management, hiring and firing, employee motivation, product development, and the like. She explained that she and her team would select their favorite bits, and I could pick some of my own. Then we would put them all together and publish the result.
The more I thought about it, the more I liked it. I could use most of the new material I’ve been writing, as well as my best essays from the past. And if it works, instead of adding to my pile of work, it will subtract from it.
So that’s the idea.
This morning, to get started on it, I jotted down the first 20 important-and-universal business principles that came to mind. Here they are:
The Fundamental Principles of Starting and Growing Almost Any Business
Even as I write this list, I can imagine you thinking, “Aren’t these too obvious to mention?” Or perhaps, “Tell me something I don’t already know.”
And my answer would be, “Yes. But all the most important secrets of success in any endeavor are essentially simple and therefore obvious if you don’t fully understand what they mean and how to use them.”
So those are 20 of perhaps 50 important lessons I’ve learned about entrepreneurship, business development, and business management over the years. Simply stated, they are just maxims. But Lindsey and her team and I could easily add personal anecdotes and researched facts to support them and turn this into something much greater than the sum of its parts.
A book? A course?
What do you think? Would this be something you’d be interested in? Something you’d find useful in your career?
Let me know on the “Contact Us” page of this blog.
axiomatic (adjective)
Axiomatic (ak-see-uh-MAT-ik) means self-evident, obvious. As used by Charles Theodore Murray in Mlle. Fouchette: “Like most generalizations, the statement that a woman cannot climb a tree is not an axiomatic truth.”
“Beating around the bush”… “Getting the short end of the stick”… “The apple of one’s eye”… “Throw down the gauntlet”… “Red-letter day”… “You’ve got to be cruel to be kind”…
Test yourself on the origins of these old sayings in this fun little quiz from TriviaGenius.com LINK