Talk Your Book: Moneyball Meets Private Equity

0:00Today's Animal Spirits Talk Your Book is brought to you by CraneShares.com. to craneshares.com slash bio, that's B-U-Y-O, to check out the Crane Shares Man Buyout Beta Index ETF bio. That's ticker B-U-Y-O, craneshares.com to learn more. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:38Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46Welcome to Animal Spirits with Michael and Ben. On today's show, we speak about an ETF that tries to give exposure to companies that private equity companies, I'm sorry I'm saying companies twice in a sentence would target. And Ben, I gave an analogy or I posited a question. Does it actually make sense that there might be a premium to these companies that are private instead of public, which historically was the opposite? And after being shut down, I kind of thought like that scene in Billy Madison. You want there to be a liquidity premium, not an illiquidity premium? Exactly. That is, make out of mercy on your soul.

1:21You know where I'm going with that. Yes. But so in the past, I think there was a much wider spread between private companies in public. And that, I think, has narrowed in the past 20 years as more money has gone in there. And these buyout funds are now way bigger than they were in the past, right? And you can't just, I think it was fishing in the barrel before, and it's not like that anymore. So this sort of private equity in a public wrapper is something that I've seen a lot of firms try to do over the years. Without the leverage. Yes, without the leverage. And that's a big piece of it. There's a lot of people say, well, private equity just gives you the S &P with leverage.

1:59And I think some people are okay with that if that's what you're going to get. But it does seem to me that, to your point, I don't know, maybe it has reversed a little bit where the illiquidity premium is not what it once was. So maybe this is just a better mousetrap for exposure to smid cap companies, right? Get rid of the most expensive, get rid of the junk, focus on profitability and things like that. Yes. I think if you just look at the small caps in terms of more high quality, yeah, we've talked forever about the 40 % of them are unprofitable. And I'm sure some of that 40 % group is tech stocks or biotechs that is going to have big returns someday.

2:33But a lot of it probably is just junk. And I think in those smaller names, yeah, getting rid of the bad stuff, that probably half the battle. All right. So here is our conversation with Greg Bond. Again, Greg is the CEO of Man Numeric and head of Americas for Man Group.

2:50Greg, welcome to the show. Oh, great. Thanks for having me. So one of the themes that Ben and I have been discussing is the rise or the transition from public markets to private markets. We all know that there used to be a whole 5 ,000 stocks in Wilshire, 5 ,000, and now there's much less. And Torsten Slock has this great stat showing that 87 % of the companies in the United States that are doing a$100 million in revenue are privately held. Private equity is becoming a bigger and bigger part of the economy. and you all with the CraneShares Man Buyout Beta Index ETF, ticker BYU, are taking an interesting approach to benefiting from the secular tailwind of private equity.

3:36So what was the thinking behind this idea? Where did it come from? Well, the idea is basically, can we look in the public markets and try to find proxies for what the private equity folks are doing? Again, a very valuable part of the economy. but in a way that we could build sort of a more liquid version of that, something that would fit more easily perhaps in people's portfolios, something that would have some scale. And at the same time, giving you that kind of exposure that you might find in a private equity portfolio. So just taking a lot of the tools and things that we've been developing as a systematic investors for many years and trying to deploy it into this space and really thinking there's some commonality of some things that we can do and in some of the capabilities there that would be quite complementary and build a very, very interesting, we think, strategy.

4:19So does that entail looking at the types of companies that private equity buyout firms are buying? Does it entail looking at different valuation metrics? How do you think about making those public markets more private-like? Yeah, it was a very, very, you know, a lot of time, interesting project for us, very much focused on trying to understand what private equity looks for in particular kinds of companies, the style of companies, what size of companies, those kinds of things and features and see if we could identify similar things in the public market. So it was really about building a portfolio that looks like those stocks and those companies in the private equity portfolio.

4:55So looking at generally cheaper, more profitable companies, operating margins are super important, but it's not just about deep value there. There also needs to be some growth opportunities. So it was key that it was a balanced approach, looking for combinations of good business models at an attractive price, but also showing some potential for growth. So that was just sort of like the kind of company. The other part is where does private equity deploy its assets typically? What kind of sectors do they focus on? I think a lot of some of the natural benchmarks that people use in the public markets for private equity are things like the S &P 500, other sort of large cap universes that aren't necessarily applicable to kind of the typical private equity portfolio.

5:40So we started with thinking about the sector focus. So, looking at what private equity deals are getting done and then mapping those over into a kind of a public market sector definition. So, rather than buying an ETF or something right off the shelf, let's get something that matches the macroeconomic exposures of private equity, which is really the sector tilt. So, that was one part that was really, really important. The other part is what size of company, right? And what's the right universe to play in? And looking at that universe and doing some research, it's not necessarily that we need to get into the really small micro cap area.

6:16What we found is that if you get into something, we use the Russell 2500 as a starting point. So think the biggest 3 ,000 stocks in the US take out the top 500. Things like that would be in the S &P 500. And then what you're left over with is called the Russell 2500. So kind of a SMID type set of companies. And the reason for that is, one, just looking and trying to match some of the long-term return characteristics. We didn't need to get as small as micro-cap. And also, practically speaking, I think building a$200 million capacity strategy is not going to help anybody in terms of what the space is and the market opportunity.

6:51So I have a three-part question, and let's see if I can keep this in order. Number one, was this trying to give better exposure to smid cap companies? Was this trying to keep up with a private equity type of investment, just in a liquid wrapper with lower fees? And or was this the type of thinking where you said, these are the companies that are actually more likely to get acquired by private equity? And forgive me for the three-parter. No, that's good. So I think specifically, it was really to proxy what is currently held by private equity. So it's really that ability to go in and see what those company characteristics were like and trying to build those in a public equity portfolio.

7:30That's different than saying, hey, I want to build a portfolio of stocks. This is generally going to outperform some broader index. So it was really about giving people the kinds of exposures that you would get in a private equity portfolio, but done in a public market way. We were also looking for opportunities for people to have some scale and liquidity to help them trade around those names and being able to go in and out in a more liquid fashion, which we think would fit very nicely in a portfolio that already has a lot of private equity investments. And it wasn't necessarily that we're targeting companies that are going to necessarily be taken out by private equity, those companies that are going from public to private.

8:10Those are very different than the standard private equity deal. They're very large, very oriented around valuation. So we're fishing in a similar pond here, but it was really about getting the right characteristics to match what we think and looking at the research of what would be in a private equity portfolio. So like a liquid private equity basket-ish, but I guess without the leverage, because that's obviously a big part of the story. I'm curious, in your study of private equity and trying to quantitatively match a private equity portfolio, how you've seen that space evolve? Because I've seen interviews in the past with Mitt Romney where he talks about, hey, in the 90s, we were buying these private companies at like a four times EBITDA.

8:53And it was just the only one of the reasons that we had such big returns is because the valuations were much lower. Are the valuations much, because obviously the valuations are higher in public markets, are they much higher or are they getting close to one another in the private markets as well? I mean, from our side and some of the data that we see, I think the multiples that are in private equity have definitely gone up. I mean, I think there's more competition in private equity space. There's more capital being deployed. I think some of the stories changed in private equity as well. I mean, back in the 90s, it may have been more focused on metal bending kind of companies.

9:22Now it's more kind of software and services type companies that would require a higher multiple. So I would definitely say that private equity is not all about valuation and deep value. And that's why our portfolio has characteristics that have some valuation to them, but a lot trying to capture some of the other components. I think it's very much an evolving space. And one of the things we hope in our strategy is that as it runs and private equity does change its stripes in terms of some of the sector focus that will pick those kinds of changes up. Do you find though that some of these small and mid-cap companies are maybe even cheaper than some of the private counterparts or is that not quite there yet?

9:56That can be the case. That can definitely be the case, particularly to the degree that private equity, if it's focusing on more of a growth story, there might be more opportunities in smaller cap public companies as well. So I think it's just generally the span of private equity is obviously quite large. And what we're trying to do again is find really companies and really mainly avoiding the companies that we don't think are in private equity portfolios. So we want to avoid the most expensive, the least profitable, the least cash discipline. So a lot of our process is just not trying to get too cute about it, but look at what we see and what we read about in private equity and then knocking out the companies that we know have a high likelihood of not being in a private equity portfolio.

10:38So it's really about screening out companies. Greg, let me ask you a perverse question. I never thought of it this way. Does it make sense that privately held businesses would be more expensive than equivalent ones that are publicly traded? And the reason why I say this is because there's been a lot of active investors, active managers that have bemoaned the fact that if nobody's going to come in and see these valuations to fruition, like, yeah, these publicly traded companies can stay cheap forever because nobody really cares about them. Whereas if a company is privately held, then there's a potential for an exit to, you know, via M &A.

11:14Like, is that so ridiculous or is there maybe something there? Well, I think there's always a catalyst and I think there are enough investors in the public market side as well that there is a unique opportunity, something that is permanently undervalued. There are people that can go in and alleviate that, go in and actually buy that company and bid it up. I think you're also getting one of the nice things, at least in the public markets, and people forget this, is that we do have audited financial statements. There's a lot of standards around that. I think the public markets do bring a level of clarity around some of the regulatory stuff for these companies and things like that.

11:49So that, yes, very sophisticated investors are doing private equity transactions, but there is a layer, I think, on the public markets of transparency, I think it actually be quite helpful. So there's a give and take, I think, between public and private, which explains maybe differential valuations at certain points in the cycle. But as anything, I think as opportunities are persistent in the market, you'll see more capital come in, which is why I think you've seen a lot of private equity capital go into the markets. And some of the concepts around, there used to be a lot more publicly traded companies.

12:19I mean, if you go back, some of that was a bit of a bubble in the 90s around the number of companies that were publicly traded. If you go kind of prior to that, I think it's more aligned with what we're seeing today. So I think really it's just the market coming to grips with kind of a trade-off between private and public. We think there are opportunities for both. And I think we're also seeing people, I think, forgot perhaps there is a cost of illiquidity. There's a benefit and a premium that should be there. But there are cases now where rates go up and other things and kind of locks down what you can do on the private market side, that having a public market equivalent or something that's a proxy or similar could be quite valuable.

12:55One of the stats that Michael and I have talked about over the years is the fact that something like 40 % of all companies in the Russell 2000 are not profitable. That number has been increasing over the years. When you go through your process and you talked about trying to screen out the worst companies, is that the kind of thing where you're trying to screen out? Your process is the first step, getting rid of the bad apples. A lot of it probably is those lower quality, unprofitable companies. Is that how it works in your process? That's definitely a part of the screening, exactly. So we take the broader, the Russell 25, so a little bit bigger than the Russell 2, so the next 500 largest on top of that, and go through and say, and screen things out that we think, again, aren't proxies or what we think would be in a private equity portfolio.

13:33And that naturally leads to a bit of a quality tilt if you wanted to find a screen out less profitable companies, companies that aren't doing good things with their cash, buying back debt, buying back shares, managing the working capital. So again, we didn't want to, I guess I said earlier, don't get too cute about it. It was just sort of let's knock out what we see, what we think is not in the portfolio. And what we'll end up with is something we take that broader set of that universe, and maybe we'll end up with about half of the universe left over after all of the screening that we do. And then we try to match the sector exposures that we have on private equity.

14:07So that's looking at taking the Russell 25, looking at all the deal activity and private equity, and then reshaping that benchmark to look like private equity capital allocations, and then we run our portfolio against that. So what does a sector composition look like? So we're typically, relative to what you find in a kind of a standard cap-weighted benchmark, we typically more software and services kinds of exposures, more industrials, you will be sort of underweight financials and REITs and those kinds of companies. So it's very much focused on trying to see where the deal activity has been and then reshaping that bench.

14:45As businesses have been gobbled up or transformed into technology companies, have better visibility into their clients, are quicker, able to adapt, therefore have higher margins and rising. Doesn't it make sense that multiples for businesses, not just publicly held, but privately held are going up as well? Exactly. I think if you have efficiencies in terms of operating margins, growth opportunities, I think you should be willing to pay a higher price for that kind of company. And I think that's the key, is that we don't want to build or have just a deep value strategy. This is about the combination of the trade-offs between growth and profitability and the valuation.

15:18And I think that's the math that private equity companies are trying to do. But also to that point about rising valuations in private equity, yeah, well, guess what? If historically a lot of the purchases were manufacturing companies or whatever it was back in the day, and now they're software related, well, it's an apples to oranges comparison. And that's very fair. And I think that's the key is that the industry does evolve over time. And you need to be aware of that and what kinds of companies are going into these portfolios. And so how far do you try to narrow things down? You got this universe of 2 ,500 stocks.

15:48I don't know what the typical size of a PE portfolio is, but where do you stand in terms of concentration and diversification? So we end up with a pretty diversified portfolio because, again, we're trying to knock out what we don't like, right? So just knocking that out. And then what's left over, we try to trade very kind of risk-aware, transactions cost to where to give a portfolio that we think is very scalable and hopefully added value for people's portfolios. So we take that universe, we bring it down into a holding. So it's a pretty well diversified portfolio. We're not trying to build a hyper-concentrated portfolio by any means.

16:23It's really trying to get a reasonable exposure that not only matches the kinds of companies, but also the sector exposures that I was talking about. So what are private equity companies looking for as they comb through their investable universe? Is it predictable cash flows? Is it potential cost savings? What do the quantitative screens look like? Yeah, so we get it. It's a blend of different things. I think, one, we do screen on valuation. So we are knocking out the most expensive part of the universe. And that's looking at a lot of cash flow generated metrics like EBITDA, EV, the gross profits to enterprise value, those kinds of free cashflow yields.

17:04So metrics that you would think would be very focused on valuation. So we start there, we knock out about 10 % of our universe just from that valuation screen. So that's important. Again, we don't need to pay deep value, but I think having some concept of value, it does align. And then it's things like profitability, different versions of profitability, knocking out again about sort of 10 % of the least profitable. We also want, again, And trying to proxy, so there's a bit of a trade-off here between what we call pure alpha factors that you might find in the public markets versus trying to match up a bit on private equity.

17:38We do look at things like debt capacity of the company. We think, again, it should be something that can have some serviceable debt around it. We're also importantly, I think this is thinking about what's in private equity portfolios versus what they may go out and acquire. We do buy companies that are cash efficient or they have good solid cash management, specifically knocking out the least efficient. So if you think about the private equity J curve, we're somewhere along that in the kinds of companies that are there. We obviously are not going to go in and sit on the board of the company and force them to be cash efficient.

18:12It's more that these companies are already cash efficient. So that knocks out, again, some of the universe. But at the same time, we also want to have growth opportunities, some private equity ideas. the sources of alpha, you buy on a relatively cheap price, you can adjust on the operating margins, and then you can leverage the portfolio. And at the same time, hopefully, capitalize on some growth opportunities. So we want to make sure that we've got some growth tilt in the portfolio, meaning that we will knock out the lowest growers. So it's not just the deep value type stocks, but there is some growth component.

18:46So that's what I call fundamental screens. And that was really a lot of the process. But since we do sit in the public markets, we do have one advantage, and that is we can look at other proxies for value added. So sort of mimicking, hopefully, some of what private equity does in terms of their value added. Some of that can be very deep industry analysis through some of our models and looking at the supply chain and the health of the supply chain of companies. We can look at other informed investors in the market to see how they're positioned. So if there's a company that's very heavily shorted, for example, we may want to screen that kind of thing out of the portfolio because there's something potentially going on there.

19:24And also just companies, back to one of the points about being more stable, able to support a debt load, companies where there's not a lot of business uncertainty, at least measured by looking at the volatility of the company, how much their shares turn over in the marketplace, given there's a lot of share turnover, a lot of volatility, there's a lot of uncertainty around that business. So trying to identify both with what we call those fundamental screens around valuation through growth and then adding in some other proxies that hopefully are trying to replicate some of the deep due diligence that private equity is dealing.

19:56Do you have a hard and fast set of rules that you follow here in terms of quantitative models or is this a more flexible approach? Yeah, so this is a very systematically implemented approach. And I think that's where another thing that we try to differentiate and bring to the table is hopefully this is a repeatable process. So everything that I just described is the way we run the portfolio and those screens and the models around it. So that's the process that we've built. And then on top of that, how do we actually put the portfolio into the market and think about buying individual names? And that goes back to both kind of risk and thinking about the risk relative to this benchmark that we've talked about.

20:37But also, what are the trade costs and being very focused on transactions cost awareness when we do these kinds of things? So CraneShares is the delivery for the MAN Buyout Beta Index. Again, the ticker for this is B-U-Y-O. MAN Group is one of the largest asset managers in the world, especially talking about private companies. So you all have a long track record of doing deals like this. Can you talk a little bit about the history of the firm or anything you want to add there? Yeah, Bankrupt's a very, basically the motto there is sort of alpha at scale, right? Providing investors alpha across different types of investments.

21:18And so some of that is through discretionary, traditional equity long short, credit long short type portfolios, but also systematically driven investment strategies. That's partly where, obviously, the ethos of this strategy really much came up on the systematic side. Other systematic, more macro-type trading strategies as well. So it's a very well-diversified, focused on delivering alpha for investors. And that is all predominantly through the public markets. But we also have some private markets businesses as well, particularly on the credit side. So, Greg, you have a, I don't know your full background, but you spent some time with the Boston Red Sox doing the Moneyball thing.

22:02What was that experience like? Oh, no, it was very interesting. I've always, you know, obviously like a systematic investing and, you know, using quantitative techniques and, you know, through after some several years here at Man Group, I think there's an opportunity to work, take a sabbatical and do some work on Moneyball type things with the Red Sox. And a lot of that was around draft strategy and sort of, we take fundamental scouting reports and turn that into something that's systematic. more systematically driven. And so those kinds of problems are always very interesting. I think getting into different contexts and seeing systematic things work in a different context and bringing that over, I think has always been a good experience.

22:41And I think you're seeing a lot of the concept of the money baltization of the world is really, we're seeing that, right? In different types of markets. Hopefully you see a little bit here in sort of a public market application for private markets. So I think just the data intensity, data driven, of decision-making is just, it's proliferating across the entire economy. And so while it started off maybe in sports and there was, you know, a really good movie around that, moving into, you know, broader parts of the economy. And I think it's a trend that's going to continue. Was that the kind of thing where there was big time first mover advantage, kind of like in the markets back in the day, Ben Graham and Warren Buffett, it was much easier for them to produce alpha.

23:19Now there's so much more competition, it's harder. Are the edges harder to find there now? I think, you know, if you're thinking in sports and some of the technology, and there's some data out there. So I think the movie Moneyball was obviously set around the Oakland A's and the Red Sox were an early adopter as well. But if you look at where the market is today, I think there's a guy named Zach Scott who has his own podcast, but does some other analysis and used to be a general manager. I think he calculated something like there's 750 people now involved in baseball alone between data analysts and technologists where the Moneyball movie, it's a couple of people, right?