Talk Your Book: The Next Big Short

0:04Welcome 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. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:34Welcome to Animal Spirits with Michael and Ben. And on today's show, we're joined by Jared Dillian to talk about what he describes as the biggest bubble in history. I didn't ask him this. I wish I did. Is this a bit tongue-in-cheek? Not tongue-in-cheek. Is this hyperbolic? And I would say, yeah, I don't actually think that Jared thinks this is the biggest bubble in history. Maybe he does. I know Jared is a student of history. But listen, he is a provocateur. He wants people to read the white paper, which is quite good. So, all right, whatever. If I quibble with the title of the paper and the way that he describes it, no big deal.

1:12I was thinking about something that Jared said after we recorded and not to step on too much material, but Jared said, I don't trust the stock market. That's his nature. And it's not just in his nature. It's because of the market that he came up in. Jared started his career in 1999. Obviously, we had the dot-com bubble bust shortly after he started. And then he worked at Lehman Brothers for a couple of years. I believe he was on the ETF trading desk and kablooey. Stock went to zero, economy in shambles, market went down 57%. And I was thinking, because Ben and I are, of course, big. We have a lot of trust in the stock market.

1:53Stock market has treated us and our investors, our clients quite well over the years. but if I started when Jared did, I don't know that I'd be that different from him. I think it's very easy for me to say, you know what? It's easier for me to say, man, how does he not trust the stock market? Hasn't he seen what's happened since Lehman? But I wasn't there. And so if I was and I saw my equity go to zero and that of so many of my colleagues, I don't know where I would be, but I can easily understand where he's coming from. He said, listen, I admit it. I don't trust the stock market as much as you guys do.

2:29I invest in these other strategies because I don't trust it. And I guess at least he admits that because that's better than investing in the stock market and jumping in and out or not. So I don't know. It's interesting to talk to someone like that who has completely different views about the market than we do. Yeah. And this, it never got contentious, but in this podcast, we push back a lot against his thesis. And the good thing about him is he's very open-minded. He doesn't take offense to people pushing back on his theories about shorting private equity. But I think we agreed for the most part in the conclusion, which is that, listen, I hope it's not a giant bubble or the biggest bubble in history because it would be – if that's true, it would be horrible for the economy.

3:09Forget the stock market. 87 % of businesses with over$100 million in revenue are private equity backed. So it better not be the biggest bubble in history. Otherwise, we're all in big trouble. But the conclusion that I think we landed was, he's like, listen, I would say there's a sentiment bubble in private equity. No doubt in private investments. Check my inbox. I've been talking about this for a year now. I get, I don't know, six emails a day from companies I've never heard of. I got a cold call last week. There's absolutely a mania of frenzy in getting investors' dollars allocated to private credit.

3:41And what I would do if I could do, or what, I don't know if I would do it or whatever, but I can't do it, so it doesn't matter. But I think what we're agreeing with is a lot of these third, fourth, eighth tier companies that are getting into the private asset space, short them to zero. Of course you can't. But the Blackstones of the world, not only do I not want to short them, I want to be long. And in fact, I literally am long Blackstone because there is a transformation in the structure of the economy, in the structure of markets. there was a transfer away from bank balance sheets. And I don't know if there's, maybe this is the hidden risk that Jared's worried about.

4:14And, you know, that's a, you know, I can't really comment on that. But these are the most powerful asset managers in the world. These are proven money printing companies. And I don't want to be short, I want to be long. So I don't know where this goes from here. I don't know. I would say it's probably a fair conclusion to say that in all likelihood, there is more money than available deals. So that should compress returns. if nothing else. But is this a bubble that's going to burst and take us all down? God, I hope not. Right. God, I hope not. Yeah, people who are reaching for different types of funds for better returns or better yields, some people will get harmed.

4:52It's hard to say like this whole thing is going to blow up, but there are going to be people who make poor decisions and are not going to end up very well. So like Ben said, I thought this was an interesting discussion and credit to Jared for allowing to push back and in no way, shape or form does this get contentious. I think this is one of the great things about getting off the internet and into the real world where you can have a discussion with somebody that you maybe disagree with and it's not like you MF-er. It's not a big deal. And I think a lot of things that we did find common ground in a lot of the things, I think maybe just the conclusion or whatever of where this goes is different.

5:25So anyway, enough. I don't want to step in the material too much. This is a really great conversation. So thank you, Jeff, for coming on and allowing us to disagree. So here's a conversation with Jared Dillian about what he calls the biggest bubble in history.

5:40We're joined today by Jared Dillian. Jared is the founder of Jared Dillian Money. All right, Jared, welcome to the show. Okay, thank you. So, Jared, you have a 48-page memo up on a site. What's a site? Is the site Short Private Equity? ShortPrivateEquity.com. All right, ShortPrivateEquity.com. So that's what we're going to be talking about today. Jared thinks this is the next big short. And maybe before we get into the current thinking, let's remind listeners that you were at the epicenter is too strong. But you were at Lehman Brothers during 2008 when everything went kablooey. So you were there for the first big short.

6:21Yeah, I was. I was the recipient of it. Um, so, you know, you know, what was funny was, you know, when I was at Lehman, um, I was very much, I, you know, I believe there was a housing bubble and I, you know, I believe that Lehman had exposure to it. And I actually was at the time I was running around with Vinnie Daniel and Porter Collins from Frontpoint and we were, you know, sharing these ideas on the housing bubble. and I worked at the firm that was totally doomed because of its exposure to it. So you've written in the past that – and the next big short that we're going to be talking about today is private equity, maybe specifically private credit.

7:04But you've written it in the past, and one of the reasons why I was so impressed with your writings is you're very honest and transparent. And you said that you have a bearish bent, particularly because the deep scars from 2008. So before we give you the mic to walk us through what you call the biggest bubble in history in private equity, is it possible that your experience in 2008 is leading you to a conclusion that might be biased from your own experiences? Oh, for sure. You know, I mean, I think, you know, there's Neil Howe who does the fourth turning and all the generational studies and stuff like that.

7:48And basically, you know, his belief is that who you are as a person is a function of when you were born and where you grew up and your surroundings and stuff like that. So, you know, I started my career in 1999. We had the dot-com bust in 2000. And I started working at Lehman in 2001. And then we had the financial crisis in 2008 and nevermind 9-11. So the first 10 years of my career were these two gigantic explosions. Hard not to be impacted by that. Yeah. I mean, I think it affects your psychology. How many coworkers and friends and peers did you see that just lost almost everything from Lehman?

8:31A lot. But I think, I mean, it's actually kind of a personal finance question because I think, you know, there was, in addition to being a housing bubble, there was a hedge fund bubble in the mid 2000s. And I think there were a lot of people that thought that was going to go on forever. And they bought expensive apartments and they bought expensive cars and they were over leveraged. And, you know, I actually was very conservative. I had a teeny tiny house in New Jersey. I was, you know, very conservative with my money. So I was actually fine. ultimately. So I'm curious if those experiences shaped you, are you a more bearish like investor or have you figured out ways to like take your hands off the steering wheel or take that psychological part out of you and be more bullish when it makes sense?

9:17Like how, how much do those emotions play into your investing decisions? You know, it's funny because, um, I, I don't have a degree of comfort with the stock market that most people have. I don't have a trust of the stock market. I trade lots of other stuff. I trade bonds. I trade commodities. I trade FX. I have a degree of comfort with those asset classes that I just don't with stocks because what I learned when I was 27 years old is that you get rug pulled. And the thing with stocks also is that they're very asymmetric. It's up on an escalator. It's down on an elevator. So I actually think stocks are harder to invest in and stay invested than just about any other asset class.

10:07So all right, let's go from stocks, which are public businesses, to private equity, which are private businesses. And the explosive growth and the shift from public capital to private formation has been massive. Torsten Stock from Apollo says that in the United States, 87%, 87 % of firms with revenue greater than$100 million are private, which is kind of nuts, like how much they dominate this economy. So what is it, Jared? I'll give you the mic. What is it about private equity that has you not just worried but calling this – I think these are your words – the biggest bubble in history? Yeah. Yeah.

10:51So first of all, if you go back 25, 30 years ago, there were like 24 private equity firms, and now there's 17 ,000. There are literally 17 ,000 private equity firms in the United States. And this statistic that you gave, I actually hadn't heard of before, that 80 % of businesses with 100 million in revenue are private. I think a publicly traded corporation is kind of a cool financial innovation. It was an innovation that happened like 400 years ago with a Dutch East India company. I think there are significant benefits to being public. I think there's also downsides to being public. You have to deal with Wall Street analysts.

11:35There's increased scrutiny of your financial statements, et cetera. But in terms of being able to raise capital, like being public is the way to go. And I think there's been a shift in the mentality over the last 10 years where firms actually believe there are more benefits to being private rather than being public. So I kind of don't understand it. I think there's more benefits to being public. So I think we're actually going backwards in time because liquidity is the most important thing in the world, right? And like that, that is the most important thing, liquidity. It helps you raise capital.

12:16So. So Jared, I want to walk you through my experience with this, because I think I came to many of the same conclusions that you did in the 2010s. And I feel like I was wrong and I've kind of changed my mind. So I came up in the institutional world and I saw all these pensions and foundations and endowments putting 30, 40, 50 % of their money into liquids, hedge funds and private equity and venture capital. And I was on the front lines of this, I was on the operational duty of managing our private equity book, which was only like 10 % of our portfolio. But that 10 % took up 90 % of my time. Because it was capital calls and distributions.

12:49And I'm trying to track the returns on these things and calculate the IRRs and stuff. And I realized, like, this stuff is impossible to report on or to understand, like, what are we actually doing here? Like, what are we getting out of this? And I would talk to all these other investors in these institutions that were doing the same thing. And I'd say, how do you actually know what your returns are on these funds, because it's impossible. You put your money in over like half the time, let's say you put 10 million bucks in as a commitment, half the time you give them like$7 million, you don't even give them 10 million.

13:17But it happens over the course of like, eight or 10 years. And sometimes the money comes back to you. And then it goes right back to them. And you're paying you're paying fees on the committed capital, not not the money they have the money that you committed to them. And so I'm looking at all this going, this is ridiculous. Like if you're not in the top decile or quartile of these fund managers, you're screwed. And guess what? Everyone can't be in the top quartile by definition. And so I looked at this and I said, these, this is like a Hail Mary for a lot of these pension funds and endowments.

13:45And there it's, it's ridiculous. And I think what I've come to realize is that that illiquidity is, is almost like a savior for the, for the, the asset class, because it takes so long. These people don't, it's not an event that happens on a single day, like Lehman fails and like the stock market falls in, right? It's something that takes place over the course of years and maybe like a decade for some of these funds. And that's where I've come to change my thinking of is that it's more of a death by a thousand cuts than it is like the singular event. And I feel like that's why they can just continue to string this out, even if it doesn't work out for these investors.

14:20I think they can just continue to string it out further and further along. And it takes way longer for this to ever have a comeuppance. What do you think about that theory? No, I actually agree with that theory. And there's first of all, you have to talk about, you know, people talk about the supply side of private equity, but you have to talk about the demand side of private equity. Yes. The demand side with the endowments and the pensions. I mean, you know, they've been shoveling money into private equity for years. And like you said, they're, you know, they're getting charged fees on committed capital and stuff like that.

14:53the returns. Look, the white paper that I wrote is fairly apocalyptic, the next big short. But there is another possibility. And the other possibility is that the returns of private equity go down for some period of time. And pension funds and endowments look at this and they say, look, I'm getting charged all these fees. I'm making three or 4%. This doesn't make any sense. maybe they get out of private equity and into public equities or into some other asset class. And the asset class just falls out of favor over time because of lower returns. And it's kind of a soft landing. That's totally a possibility.

15:38I don't think that's how it's going to play out. I think liquidity always finds a way. And I'm not sure the mechanism, I'm not sure how it's going to happen. But when you have 17 ,000 private equity firms, there will be a forced liquidation at some point. There will be a forced liquidation. That's what I believe. That's how markets always find a way. So when I read your post or your white paper, I was reminded of the quote from the judge and my cousin Vinny, where he says, that is a lucid, intelligent, well thought out objection overruled. And I think my conclusion is similar to Ben's. And I agree with both of what you just said, which is that I think that returns going forward are going to be lower.

16:31And I almost don't see any way how that doesn't happen. Yeah. Because there is more money looking for deals than there are deals available. And Jared, I know you're very big on the sentiment stuff. I got a cold call the other day from a private credit company. I get emails. I get a dozen emails a day. And why is it happening? The story is very simple. Call it 30 % of institutional portfolios are invested in private vehicles. They're not going to go to 70, okay? The juice has been squeezed. And so what's the next frontier? It's wealth management. Because the ordinary investor, the average millionaire next door, has effectively 0 % of their portfolio exposed to this asset class.

17:19And so the dam is opening up. And yield, in particular, with this private credit, is an extremely easy, compelling sale to the end investor. And so there is such a flood of demand from retail investors, let's call it. So does this end well? I don't know. I would think that the most likely outcome is the returns. I don't want to say go to crap because it's a wide spectrum. But the returns of the asset class are going to be lower, whether it's private equity or private credit, than they have in the past. I just don't see any way around that. Yeah. I mean, private equity, if you look at this, like private equity made sense in the 2010s, like the mid 2010s, because rates were zero and companies, you know, private companies were trading at four or five times EBITDA, right?

18:14Right. And now rates are 5 % and companies are trading at 10, 12 times EBITDA or more. If you have 17 ,000 private equity firms competing for deals, there's just, like you said, there's just no more deals. Like they've gone to ridiculous prices. And as a result, there's no exits. Because if you buy something at 10 times, can you realistically sell it at 15 times to somebody else, you know, so there's no exit. So, you know, the number of portfolio companies that are being held for more than five years is skyrocketing. The returns are going to be lower and, you know, private credit, you know, I think about high yields on stuff don't really get me excited.

18:59They kind of get me scared. You know, if you're looking at like 10 to 12 % yields on something, there's usually a reason to be worried. And I think banks are more discerning when it comes to lending money to companies. And I think the bond market is more discerning when it comes to lending money. But I think endowments and pension funds are less discerning. I think they're less discerning as lenders. And I don't think it's going to end well. Let me take the other side of that argument just for the sake of conversation. So when banks did these syndicate loans, they would get a bunch of hedge funds together or institutional investors or whoever it was, and they would package the loan.

19:45They would get it off their balance sheet. They would take the transaction fees. And if something went poorly, then you would have the distressed investors come in. You would have the hedge funds suing each other. And it would be really a knife fight for every man for himself. with these private credit funds, and it's a loan from one lender, and it's their reputation on the line, and their investor money on the line, and their carry on the line, and they have the ability to either terminate or do a refinance or something like that to extend the term of the loan to be more favorable for the company, that could put a floor under this.

20:18But you might say, exactly. That's not a good thing. That's a bad thing because eventually the bill comes due and you It can't term it out forever. Yeah, exactly. Jared, is your short thesis like you should go out and short these publicly traded private equity companies? Or is this more of a short of like the investors you're going to get screwed? Where do you fall on that? Well, there's really three parts to it. One is the trading part. You're just a trader and you want to profit off of this. So really, the only vehicle is the publicly traded private equity firms. So Blackstone and KKR and Apollo and TPG and Carlyle, right?

20:58Like it's basically it. So you can short those stocks. You can buy puts on those. It's ugly. I bought puts on Blackstone last December. I bought some in 25 and some in 26. The 25 options are pretty much worthless at this point. I've lost some money on that. So I'll try it again if I see some weakness in the stocks. The other part of this is there's, I think it's important. There's a lot of people in this country who own small businesses and now is an incredible time to sell to private equity. You probably saw the article that was in the journal a couple of days ago about these HVAC companies. You have these blue collar guys who own HVAC companies that are getting bought up by private equity for like 10 or 20 million.

21:49That's unbelievable. They're living in a gated community. Like they're done. Like they, you know, they're set. So if you, you know, if you're 60 years old and you have a business and you have the ability to sell it, you know, the solution to that is to sell it now, not five years from now or 10 years from now when the valuation is going to be lower. I feel like this is just, it's a, it's a structural change, which sounds dangerous to say out loud, But I actually, I bought, I own Blackstone and Blue Owl, not because I am bullish on anything other than the very basic fact that there is so much demand for these investments.

22:26The end investor is just shoveling money in. And I don't know enough about the underlying loans to really ascertain. I'm not looking at the actual financials of the companies that they're loaning to. I understand the concept of it. But what I understand and what I see is, hey, it's an uptrend. And B, there's just so much demand from an end investor. So where does this go? How does this end? I mean, obviously, we'd all love to see the future. But if you had to guess what a catalyst is, is it just a recession and liquidity dries up and everybody's just in trouble? It could be a recession. It could also be interest rates skyrocketing, right?

23:04Like, let's say one of these ding-dongs gets elected and the budget deficit goes from$2 trillion to 4 trillion. We have all this issuance. Tens go from 4, 4.5 to 6, 6.5. We just have this complete meltdown in the bond market. That's when things get really ugly for private equity. So they are very rate sensitive. The private equity, the publicly traded private equity firms actually, when rates were declining over the last six months, they actually did really well. So they're very rate sensitive. Or it just could be economically cyclical. We head into a recession and that's the catalyst. And yeah.

23:42I do think that your liquidity point on if there is a recession, what I saw during the 2008 crisis was you had this denominator effect where the private equity companies take so long to mark their books down, right? The stock prices get marked down immediately in publicly traded markets. But the privately traded companies, they take 18, 24 months to maybe catch up. And so what you do is you have your portfolio, if you're in endowment, and you have 30 % in private equity, that 30%, if the stock market crashes 40%, Your 30 % is now up to 40 % or something, or 45%. And you go, if I'm getting back to my weights that I picked for asset allocation purposes, I have to sell some of this private equity to get back in line with my target.

24:22And that's when you start seeing these huge discounts, and you realize what these companies are actually worth. That's actually a point where I could see, to your point, where, okay, there's some sort of reckoning here. The only thing is, I agree with you on the returns coming down, and that means that the carry fees are lower for these companies. The thing is, is that they still charge the one and a half to 2 % management fees. And I think there's so much more money in there that they can live off those management fees. They don't need to carry fees anymore. So they call them fee-related earnings.

24:48And if you listen to the conference calls, they are just going up and to the right as the demand continues. I guess - The private equity owners make way more money than investors. Yeah. Yeah, I don't want to short, I don't want to short, I won't name any names, but these are some of the most powerful, richest people in the world. And I know liquidity finds a way, But man, these money people, they find a way too. I think that part of the frustration that a lot of investors have, particularly investors in liquid markets, it seems unfair. It seems like an illusion. Cliff Asnis is constantly talking about this.

25:22It seems like an illusion. And we're all in on it. And I get it. It does seem unfair. But this is the thing. It seems like they're in sort of like a gated castle. And I hate to use the word impenetrable because, of course, nothing is. but it does seem like the advantage of illiquidity and being able to just push it out. I don't know what ends that. I mean, it would have to be a recession, I would think. Yeah. I mean, I think illiquidity is viewed as an advantage until it's not, until there's a get-me-out moment, right? That's really what could happen. There is no get-me-out. That's the thing. What are you going to do?