Episode 409: Investment Banker - What Private Equity Doesn't Tell You

28:03So if you're down 5 % a year in fees, it's a little hard to see how you're going to keep up with the stock market or the real estate market or the private credit market for that reason. So let's talk a little bit about methodology, because maybe you can talk about why it's so difficult to answer what seems like a simple question, which is whether, in fact, private equity has outperformed or underperformed public equity. Well, these numbers are available. You can look them up on the internet. And as I pointed out, Bain Capital came out recently. McKinsey Capital came out recently. State Street came out recently with their 10-year charts.

28:38That means you've got to go to the internet. You've got to look at two or three McKinsey reports to find out which one, and you have to scroll through it and find the information on page 52 or something like that. So that's a little bit of a problem. And that only shows the internal rate of return, which can be manipulated by the private equity funds. McKinsey just takes these numbers off a database. Same with Bain and the others. And so the numbers or even these numbers that show a relatively poor return relative to the public benchmarks assume that the unsold values are accurate. So one, there's trouble getting information.

29:18If you want to get more detailed information, like how does the particular fund compare to a public benchmark, that's tougher. You've got to subscribe to a private alternative database that keeps that kind of information. And that's going to cost you$25 ,000 a year. In my travels, I've learned that neither the New York Times or the Wall Street Journal Financial Times subscribes to such a database. They think it's too expensive. I wouldn't have enough experience with the state pension plans to know if they subscribe to that database. They might. The Hopkins Endowment does subscribe to it. with the Hopkins endowments underperformed a 60-40.

29:59So I'm not sure the 25 grand has done a worthwhile expenditure. It's going to be bad for people that want to get that kind of information. It's just going to be hard to lay your hands on it and then to analyze it. Asking a retail person to do that is really a stretch, in my opinion. The other thing is that the media has been pumping up private equity hedge funds, et cetera, private credit, claiming these guys are all geniuses. And they've been part of the hype. They've been enablers. They're getting a little more skeptical the last two years. But with all the hype, it's very hard for someone to get through it.

30:36Lastly, the private equity industry or real estate industry or what have you, they've got millions on public relations campaigns. You can see their advertising on TV now. You guys probably get emails asking you to buy private equity funds. Of course, they have conferences and stuff like that. So it's an advertising machine. They've also got a pretty powerful lobby here in Washington. Maybe they have the same thing in Ottawa that tries to keep everything super secret. So it's very hard to get through the clutter, the fog of information to get the real truth. I think it's even harder than you made it sound.

31:15Like you mentioned the reports from Bain and I think McKinsey where they show underperformance, But then there's, I won't name them, but there's a Canadian firm that sells private equity to retail investors and they show historical performance going back to 2001 where private equity is beating public equity by almost 3 % a year, net of fees, apparently. There is a paper like in the Journal of Private Markets, 2025 paper, that says that buyout funds have outperformed net of fees by 3.8 % after adjusting for a whole bunch of factors. But it's such a messy thing to benchmark and calculate the performance of that you can have Ludovic Falapu on one hand saying there's been no outperformance.

31:54And then you can have this other paper saying it's been almost 4%. And the data are just messy enough where I think you can choose how you want to interpret and report the results. I agree with you that you can manipulate the results to get the answer you wish. It also depends on what year you pick as the start. So if you pick a bottom fishery year like 2001, where the stock market was beat up, then private equity is picking things up cheap, you might actually beat the market. But if you go 20 years back, I don't think it can be manipulated that well. Now, you know, a lot of times I've seen some of the big firms say on their websites, they beat this and that.

32:33But there's often lots of footnotes, as you point out. No one's really checking the marketing claims to see if they're true. There's no SEC regulation in this country for private assets, you know, whatever claims they make. Even if they sound too good to be true, the government doesn't analyze their marketing and say it's exaggerated. it. I've sent them a few. I'm not an SEC lobbyist. I'm not a lawyer for some citizens group. If you send something to the SEC as an individual pointing out that one of the big LBO firms is exaggerating returns or just saying bad information, they just tell you to kiss off.

33:13All they want to talk to are big firms and big law firms. That's kind of their purview. It's just tough. If the government's not checking on any of this stuff, How's an enlightened individual going to get through? It's difficult. Our listeners are somewhat familiar with the problems with IRR. We had Ludovic Fallopo on this podcast a while ago and talked about that quite a bit. Can you talk about what performance measures are better for measuring private fund performance that you've used in some of your research? Well, I think the most accurate one, the most relevant one is something called the public market equivalent, which is the slang in the industry.

33:50It's the PME, public market equivalent. So the idea behind that one, which is invented by a couple of professors like 10 years ago, was, OK, we're going to look at the cash flow of this private equity fund year to year. When did they make the investments? When did they cash out? Because these funds last like 12, 15 years now. and they would assume there was a hypothetical index fund investing at the same exact time in exact same amounts. And then as time went on, when the fund six, seven, eight, nine, ten years later started selling, this hypothetical pretend index fund would then sell their stocks in the same manner and then they could match it up.

34:36The public market index fund is designed so if the statistic is one, that means the private equity fund beat the public market or match the public market. If anything above one, they beat the public market. Anything south of one means the fund did not beat the public market. So I think that's the most accurate one. The problem with that is the private equity firms in their advertising and marketing documents never mention that because if they did, people would see how lousy they are. The PME is only provided by these big data services. If you want to find out the PME of all the private equity funds that you've heard of, Goldman Sachs, Carlisle, all those guys, you got to pay$25 ,000 to get the number calculated.

35:27That's pretty expensive. I mean, a firm like yours, I guess you could buy it and you could distribute the results to your clients. Of course, that might be prohibited under the terms of the contracts with, say, Prequent or PitchBook data services. But you would then have that kind of knowledge, and you could then pick and choose, even though, as you said earlier, it's tough to pick and choose because there's very little persistence in the business. But that would give you some idea of who's doing well. So the IRR, as you said, could be manipulated. The other one, which is popular, is called the TVPI, which is total value in versus paid out.

36:04That one's harder to manipulate as well. And that one is widely distributed. And that means if over time, some institution puts 100 million into a fund, you know, after say 12 years, the 100 million is one, you put in 100 million. And then the common TVPI and private equity would be 1.5. All the funds would average to 1.5 over that 10 or 12 year life. So you put in 100 million, and you cumulatively got back 150. So 150 divided by one is 1.5. You might say, well, that's pretty good. I'm making 150%. You know, I'm making 50 % over what I put in, but that doesn't factor in the time value of money.

36:49The math is pretty complicated to do that, but you might only have a return of 7-8 % a year if you do all the math, which is not as great as they advertise. Talk a little bit about how survivorship bias affects private market performance data? I mean, this is an issue in most kinds of performance reporting in the investment industry. How does it factor into this methodology? Survivorship bias is, as your listeners might have already figured out, a lot of the funds that fail, or let's say they don't fail, they don't go bankrupt, but they have returns that are a lot less than desirable. They simply close down.

37:28They sort of disappear into the wilderness or into the fog or to space, and you never hear about it again. So they stop filing their returns, and we kind of never hear about it. They might have been in the statistics early on, but when they stop filing, they disappear from the statistics. So you sort of have a lot of the losers fade off into the sunset and the winners are the ones left standing and the ones that go into the databases. So there'd be a somewhat higher rate of return reported by the databases than would be totally accurate for the industry. The other thing I should point out, which is not directly connected to survivorship bias, is the fact that even the biggest and best data service, which I consider frequent in private equity, only covers about 60 % of the universe.

38:20The 40 % don't report to frequent. Reporting to frequent is voluntary. They don't report to frequent. So you might say, well, where's frequent get the data for funds that don't report voluntarily? Under the Freedom of Information Act, they would try to get the data from state pension plans that would tell them what the cash flows in and out of these areas, non-reporting funds are. But even that has got holes in it. You've got a lot of information that's simply not there as you would have in the public market, which is just the way the private equity industry likes it. They don't want any accountability.

38:52They don't want anybody to really know that their funds aren't doing so hot. It's a great business for them. It's one of the best businesses ever designed. It's the same with private credit and private real estate. The non-reporting, I know it would be hard to study by the nature of the fact that they're non-reporting. Do we have any idea what the performance of the non-reporting funds looks like relative to the reporting funds? Like, are all these funds that don't report doing worse? It's hard to say. I mean, a cynic might say, well, if they're not reporting, they must have a reason for it. That reason would be we're not doing so well.

39:24When I've asked people in the business about it, I say, why don't they report frequent or pitch book? They say, well, our fund's doing so well, we don't have to report. We don't have to have frequent or pitch book tell everybody how well we're doing. We want to keep it an absolute secret, Jeff. It doesn't make any sense to me. Why would you do that? I mean, if you're doing really well, you want everybody to know. Interesting though, that's what they say because it's plausible, I guess. It is a relatively tight market. It's not like they can go and find investments if they triple their fund or whatever.

39:52It's plausible. If you've done doing better than everybody else, I mean, how do you make more money? You go out and raise a couple more funds. And if you've got a good track record, you should be able to do that. So the logic for keeping it a secret would seem odd to me. Yeah, it's tricky. I hope one day a study comes out that somehow manages to get a bunch of non-reporting fund data and tells us what it looks like. You mentioned private credit, which we've not talked much about yet. How has it performed relative to risk-matched publicly traded securities? Private credit is the next crazy thing.

40:27It's grown by leaps and bounds. Since 2015, it's probably tripled or quadrupled in size. In part, the private equity returns, as I've mentioned, have flattened out. So Wall Street had to think of another. What do they call Wall Street in Toronto? I forgot because I've been up there a few times. Bay Street. Bay Street. Okay. So Bay Street, they got to think of another product to sell, even though private equity is still selling. It's not quite selling as much. And so private credit is the next hot thing. in private credit, even though it's supposed to be exotic, super secret, doing all kinds of rate returns.

41:05The basic idea is that 80 % of private credit is loaning to leverage buyouts. So private credit is essentially privately held junk bonds to various leverage buyouts. Most of them are kind of small deals,$200 million,$300 million. But some of them are really large. You see some $10 billion deals that have been financed mainly by private credit. And so they form syndicates, almost like you would have in a big bank syndicated loan. So private credit is growing because they're really replacing the banks in a lot of these smaller deals. They run around with the same claim that private equity does, that they beat their, I hate that word, risk-adjusted benchmarks.

41:48You can never show what it means. But the professor from UC Irvine and I, who did this study recently, which I know you two know about, which was an independent study. I didn't get paid for it. I'm not getting paid to sit here. Like a lot of people in the business, you know, they get paid to show up on podcasts and doing this for nothing, is that the study pointed out, which is the first study of its kind, you'd say, well, if$2 trillion has been invested in private credit, has anybody analyzed whether it beats a benchmark that's publicly traded, that's totally objective? that no one ever did. I was surprised.

42:22No one ever did it. They just didn't have the information or they just didn't feel like it. There were a couple of people that touched on the subject, but nobody just sat down and did it, which is what we did. And it was published in a journal and people can look it up. A lot of people called us after the article was published because it was such a novel approach and something original. And so we looked at 200 private credit funds, North American private credit funds, as I said, mostly invested in leveraged buyouts. So it's all floating rate debt. So it'd all be junk bond rated because it's a very leveraged company.

42:56So junk bond for your listeners might be a single B credit by Moody's and S &P or triple C, sometimes they're B plus or double B minus. So they're junk type quality. We looked at the returns just for seasoned funds that have been around between five and 10 years. And there was no evidence that they beat a public ETF that invests in floating rate junk bonds. No evidence at all. It was basically very similar. It surprised me a lot. The other thing we noticed, which again surprised me a lot, surprised my colleague, Mike Immerman of UC Irvine, which by the way, just hired the tallest college basketball player in the world, seven foot nine.

43:39They just hired him yesterday or enrolled him in a school, by the way. So we looked it up. And the junk bond ETF, the returns were very similar. Now, the thing that surprised me and Mike was that a lot of the loans in the 8 to 9, 10-year age range, you think would have been fully liquidated, fully paid off. But no, 30 or 40 % of the loans had not been paid off or not been sold. So again, you had an overhang of unsold or unliquidated loans, much like private equity where you had a big overhang of unsold companies. There have been some articles about unsold or unliquidated loans that private debt funds are keeping them alive by letting them defer interest in principle.

44:26You know, I've heard these stories, but this is a private business. It's very hard to get your hands on the information. I'm quizzical about why everybody's flocking to private credit when there's no real evidence that it beats the public market equivalent, yet the fees are quite high and you're locked in for 10 or 12 years. So another strange happening in the alternative space. The 7 '9 transfer, by the way, is Olivier Rieu, who is Canadian. Oh, really? Okay. He's from Quebec. I think there's a lot of good basketball players that come out of Canada. Not bad. I played basketball at Northeastern University in Boston.

45:05Oh, okay. Fine university. I'm six foot 10. You can't tell when I'm sitting down. Yeah, I used to play a lot of pickup for like 20 years, so I enjoyed the sport. Nice, nice. You have a published paper on private credit performance. And after you wrote that paper, Cliff Water, who is one of the big private credit managers and a consultant in that space, they wrote a big long response, which I've read saying that your analysis was basically wrong. What do you think about their response? Well, I had talked briefly to him before the paper was published. Then he did that two or three page or four or five page critique.

45:44A couple of things. One is his critique really focused on business development companies, which are kind of similar to private credit funds and that business development companies or BDCs, as we call them, invest heavily in private debt. So they would do the same kind of deals or investments that private credit funds do, except some BDCs are publicly traded, a lot are private. His is mostly private, I guess. It's not quite apples to oranges. There are significant differences between the BDCs and the private credit funds. Secondly, we asked for where he sourced his data that proved our report wrong, and we offered him the chance to publish his findings in a journal, and you never heard from him.

46:33So I'm not sure whether he thought he got enough public relations impact from writing that report or not. I wasn't quite sure, having read his critique, whether he fully accounted for the fees that the BDCs charge or whether he was just calculating the returns that were gross of fees. I think he included some of the fees, but again, he wouldn't really reply to us. So it was kind of hard to figure out what his critique was all about. Exactly. I'm a little skeptical of it because I thought if he really wanted to tear us apart, he ought to just publish a paper. He gets half a lot of his employees just write it, crunch all the numbers, but he decided not to do that.

47:15Interesting. Jeff, how well do you think retail investors specifically understand the relatively poor performance of private equity and private credit that you've enumerated here? I don't think they really do. If they did, they'd stay away from it. But as I said, there's been an ongoing hype in the media, business newspapers, podcasts, websites, websites, business magazines, you know, they've just all been pushing us for so many years. As I said, they got kind of skeptical. You got to think of human nature. Wealthy people just don't want to put their money into an index fund because it doesn't sound sexy enough.

47:53So they always want to put some money into an exotic private equity fund or a private credit fund or hedge funds, you know, so they can tell their friends at the tennis club, I just did this with Carlisle, I just did this with XYZ real estate fund. It just sounds better. They're not able to withstand the hype. It's a little tough to do that. So there's kind of ego reasons and maybe illogical motivations that the three of us might think don't make sense. But for the average retail person, they don't quite get it. I can understand putting a little play money of your portfolio in some of these exotic things just so you got something to talk about and follow.

48:34And I might say five to 6 % of a portfolio. I'm not in your business. And you got to realize a lot of people in your business, they got to generate fees and you get higher fees from pushing alternatives as opposed to public ETS. Yeah, there's a chart recently from the Financial Times showing the amount that has been paid from private funds. I'll see if we can find the chart and put it in the video. I think I saw that article. It's like$200 million a year. And it just keeps going up, up, up. So there's potentially a conflict of interest there, where if wealth managers are being compensated to place dollars in these funds, that would be an incentive to do that.

49:13Yeah. I mean, look, the concept of fiduciary obligation, which is something you hear tossed around the United States a lot, I think that's been dead and buried for years. If it was enforced like it should be enforced, there would be very little private equity and private real estate outstanding that most of the money would have gone to some kind of index ETF or some public equivalent. I think it's harder than that because as you said, it's hard for you to get an audience to talk about all this stuff. And it's a lot easier for the folks who say, well, actually, no, private equity has performed really well.

49:47And if we're in a situation where we have to say, what does a fiduciary invest in? I think there are enough people who would say and try and convince other folks that as a fiduciary, you have to invest in private equity? That's what the U.S. government has been saying. You know, it's not been, it just came out with this new ruling to stuff private equity and private real estate, et cetera, 401k funds. If you look at the executive order and so on, that's trying to promulgate this policy. They're saying the exact same thing. I just don't think it's true. I've talked to a few wealth management conferences, not much, but sometimes occasionally the organizer of a conference, you know, might want some kind of contrarian view to entertain the spectators.

50:30And I feel like a skunk at a party. It's very hard, you know, to get them convinced. And, you know, while they think what I say is somewhat amusing and different, I don't think many of them really take it seriously. Probably even fewer of them look up the source data for the studies I've written with my colleagues. Yeah, it's like trying to convince the world that smoking is bad when all the doctors are still endorsing it. Same with lots of other things, smoking, drinking, hot smoking, and so on. It's hard to get people to veer off from pre-established beliefs. You've talked a little bit about this, but when we talk about the returns of private funds, how much of an impact do unrealized investments, like non-market tested valuations for companies that have not been sold, how much of an impact does that have on the performance that we see reported by funds?

51:19Well, the performance is largely based, even for seasoned funds that haven't fully liquidated, is in large part based on these unsold values. So if you got 20 % or 30 % unsold after 10 years and you're computing the IRRs, a high percentage is based on these unrealized gains. Before I was writing this article out of curiosity, I picked up something by a money management advisor called Upwelling Capital. And they actually went through the trouble of looking at how did these unsold values from year 10 to year 15, when they were fully liquidated, how did they evolve? Were they accurate unsold values?

52:00Upwelling concluded that they were overestimated by about 20%. Let's say you had a billion-dollar fund and you've liquidated$700 million by year 10. That leaves you with$300 million you haven't sold. And so Upwelling concluded that looking at dozens of funds, that that$300 million really wasn't worth$300 million. It was worth about 20 % less. So that would be, what,$240 million. So$60 million of your claimed unrealized gain was phony at year 10. and you use that phony claim to help you market new funds. Again, you might say, well, gee, doesn't that sound crooked? Isn't that illegal or something like that?

52:42But there's no regulation in private equity or private credit. The government, at least the United States, is totally absent from regulating this industry, even though it's very large. So they regulate a lot in the public debt space. They have a lot of regulations, public stocks, as everybody knows. But in private equity, it's the Wild West. There's no sheriff in town. Just to clarify, you had mentioned like 30 % as a number of unsold holdings. Was that just as an example or that is pretty close to the average one would expect? Well, if you look at public equity funds, you can't expect the public equity fund that's only been around four or five years to have sold much.

53:22They only started buying it a few years back. But if you look at older private equity funds, nine or 10 years old, yeah, it's 30%. The stuff hasn't been sold yet. And for some of the funds I looked at last year when I was doing that study, it's as high as 50 or 60, which is remarkable. You say, gee, if they started 10 years ago, you'd think they'd sold most of their stuff by now. But I think that's a little surprising to see. And as I pointed out a few minutes ago, private credit's the same problem. You still have a high percent of the assets that are not sold. From the perspective of the industry, if you're running a private credit or private equity fund or private real estate fund, you start with one fund, let's say 2016, 10 years ago, and you spend all the money by 2019 or 2020, then you're ready to open a new fund.

54:14The tendency is to exaggerate how valuable the unsold assets are for the prior fund so you can motivate people and institutional investors to buy into the next fund. So it's a great business. You basically have the private equity funds creating their own homework. They're telling investors, this is what it's worth. Now, when I presented this dilemma for institutions like Illinois Teachers Association or some college, but I pointed out this issue, I said, why don't you guys, before you invest in one of these funds, send in a SWAT team of experts, accountants, lawyers, to look at the underlying values of each company in the fund before you buy the next one.

54:59Despite these funds having billions of dollars, they say, well, we can't afford to hire a team of experts to look at it. We have to take the fund manager's word for it, which is a complete opposite of when I was in the M &A business. If some company was buying a$50 million business in an acquisition, they would send in accountants, lawyers, IT experts, it would cost them hundreds of thousands of dollars to investigate everything about the business to make sure the numbers were accurate. We were acquired about a year and a half ago, and we went through that. And we have now done a few acquisitions of our own since being acquired.

55:34And we have similarly gone through that on the other side. Well, then you know exactly what I'm talking about. The buyers are lifting every rock, seeing what's underneath. They're checking all your numbers and legal documents. But But strangely, in the private alternative investment world, there's none of that. The LPs, as they call them, the limited partners, which are the big institutions, they don't do any checking at all. Now, they would say, well, it's up to the gatekeeper to do the checking. That's what I'm paying them for. But the gatekeepers don't do it either. Something that I'm really curious about, and I've seen mixed information on, is what effect does private equity have on the operational performance of the private companies that they invest in?

56:14So the advertising campaign is maybe we are paying a little more for the companies than we used to, but we have the management expertise as private equity fund managers to improve the business and streamline costs and boost revenue and that sort of thing and make it a better company. There's only one problem with that marketing tactic is it's never been proven. It's very tough for independent observers who tend to be in academia to get the information. Some of them have said, you know, I've looked at companies that were taken private and then taken public again five years later. And then I compared those companies to probably companies that were somewhat similar.

56:55And the private ones seem to do a little better. But it's very hard to get the right data points. And then you've had other academics that have somewhat proved the opposite, but they're very inconclusive studies. And you really can't trust the private equity managers association, private equity managers themselves. They have a lobbying group in Washington that churns out some reports, but you really can't trust them. And so if the independent experts can't come to a conclusion, I don't know how they can keep running around and saying that. But like I said earlier, there's nobody stopping them.

57:31The government doesn't stop them from making these claims. And I don't think any of the investors that have been hurt by losses are ready to step up the plate and sue them. So we've talked a lot about the performance differences between public and private equity and credit. Let's talk a little bit about the various risks. With a focus on retail versus institutional investing, what are the different risks that one would face with private investments as opposed to public ones? Let's forget the returns for a second. The main risk from an individual investing in one of these private alternatives is you're kind of stuck with them for 10 or 12 years.

58:13So let's say you need the money for health problems or you want to buy a house in Florida, what have you. It's tough to liquidate them. There might be a small secondary market, but there's going to be a big spread between the bid and ask. And so you're going to feel ripped off if you only get 60 cents on the dollar for your secondhand private real estate fund. Now, some of the funds for retail, every three months, you can put some of your interest back to the fund manager and get paid net asset value, I think. But that's only 5%. So it would take you a few years to liquidate it if you needed the money.

58:53So that's the main risk is just getting your money back if there's some kind of emergency. The risk gets underappreciated. A good example is in Canada recently, we've had a bunch of private real estate funds that have done reasonably well for a while and the returns looked super smooth if you put them next to a public REIT. But then recently, real estate prices in Canada dropped quite a bit and a lot of those private real estate funds that had done well and looked super smooth going up, all of a sudden you couldn't get your money out. Well, did they have a three-month option to liquefy some of your holdings.

59:25But I mean, just the average investor in that fund. There's a couple of different things going on. One of them is going to go public. They're going to go through an IPO process, which is going to be interesting to see the outcome of. One of them does have a redemption option that is available. It's like you said, it's the limited amount that can be redeemed. The point is that you don't see the volatility. Then when you want liquidity at that smooth value that things have been reported at, you can't get it. When times are bad, In good times, it's fine. Well, let's see. Didn't Blue Al want to merge its private fund with a public one?

59:56And then the private one, you know, it's had a net asset value of$100 to share. And the private one had an asset value of$100. And the private one was$80. If you merged it to the illiquidity discount of a closed-end fund and all that sort of thing, the private investors could only sell at$80. So I guess there was a rebellion happened a couple of months ago. Tricky stuff. There was one other private debt and real estate fund in the US, not in Canada, that did go through an IPO. And immediately, its market price fell way below its previously reported net asset value. What did the Canadian government do about that?

1:00:31Well, that was an American one. I think in Canada, it seems that the regulatory stance is that these are generally in Canada, what are called as exempt market products, where the regulation is a lot more chill. It's exempt market. And so the regulators, I believe their stance has largely been, these are exempt market products. We're not going to do much. It's the same here then. It's very similar. Yeah. Which then puts the onus on the investor, on the end investor, when they're signing those exempt market documents to realize this might be risky. Yeah. Assuming they read them. I mean, when you look at documents like that, they're like 10 pages long of legal mumbo jumbo.

1:01:09I mean, there's probably three sentences that are relevant, but it's hard for the uninitiated to pick out those three sentences. It's sort of like when you read a private equity or private credit document for the investors, it might be 80 pages long. And if you look at like the carried interest section, I've done many merger deals and private credit deals and all that sort of thing. If you look at the 80 page document, look at the four or five pages covering carried interest. I mean, it looks like hieroglyphics to me. It's very hard to decipher and figure out the formulas. I can't do it. How someone, even a trained lawyer with some finance experience, supposed to do it or even take the LP, who's the Harvard Endowment or whatever, that's got a limited staff and doesn't like going over legalese.

1:01:57It's going to be challenging for them. We've talked a lot about the costs of private investments. In fact, Ben, even right off the top, you'd kind of mentioned that a lot of these funds actually do show some outperformance gross of fees, but not net of fees. So Jeff, can you give us an idea of the range of fees that you will see in private markets and how that might compare to public equities now, which have become so extremely cheap? Let's take a private equity fund, then I'll talk about private credit. So a private equity fund at the institutional level might be 1 % to 1.5 % of commitments. So it's really not 1.5 % of the assets invested because it takes several years to invest.

1:02:44So it's 1 % or 2 % on commitments. So if your commitment is$100 million, you're paying$1.5 million a year, even though the first few years, it may have only invested$20 or$30 million. So the fees could be 7 % or 8 % for the first two years. So that would diminish the returns, as I'm sure is obvious to you. When you do all the number crunching, then there's a performance fee that's usually based off a minimum return. The number is usually 8%. Sometimes it's 7%. So if the fund returns a cumulative investment of 8 % a year, anything over that is essentially split between the manager and the fund investors.

1:03:27On average, the fees annualize this and get out your calculator, computer, spreadsheet and all that. You'll probably see that on average, the funds are 2 % to 3 % a year in cost. The ETF, as you guys know, big ETF that's basically mirroring an index of some kind might be one-tenth of 1%, which would be 10 basis points is what we call it. The private funds would be about 25 times more expensive. You just have to be a good investor of private companies to beat the overhang of fees of over 2 % a year. You got to be a really great investor. Most of them are pretty smart, but they're not that good to beat that difference in fees, which cumulatively, as you imagine, is 15 % or 20 % of your investment.

1:04:16So if you're a football fan, the publicly traded equity index fund starts at the 20-yard line to get to the goal line. And the private equity funds starts at the goal line. They got to go an extra 20 yards to just match them, much less beat them. So the fees are very high in private equity. And that, I think, hurts the performance. Now, there's been some fee pressure in the business as a result, but it surprisingly hasn't been that effective. The other thing, when I learned studying private credit, I looked at it, I was in it for a while, but The funds there are very expensive as well. So you would think with private credit, it'd be easier and therefore cheaper for the private fund manager to make investments because they're fixed income.

1:05:05They're not as risky as equity. You just don't have to study the company as much. But the fees there are usually around 1 % or 1.25 % fixed per year. And then there's a performance fee, which I think is around 7 % per year. And once it breaks 7 % cumulative annual return, then I think the split might be 15 % of the profits to the manager and the rest, 85 % go to the investors. The interesting thing about that was this 7 % return, you say, well, gee, that sounds pretty good. But treasuries are around four or four and a half US treasuries. And these junk bond loans that float usually at 4 % or 5 % above the Treasury, so they might be 9 % or 10 % in some cases.

1:05:56And the 7 % was never adjusted for the rise in interest rates. You look at subsequent private credit documents. So I think the private credit is probably a better business than private equity for the industry. The fees are similar. I think the returns will be more stable and the performance fee is pretty good. The other thing that's great about private credit versus private equity is in private credit, the fund manager only has to put up one or 2 % of the principal of the whole fund. So if it's a billion dollar fund, they only have to invest 10 to 20 million. In private equity, they're supposed to put up 40 to show their confidence in the fund.

1:06:39So in the case of private credit, you'd recoup your entire investment in two years. Private equity might take a little longer. We've touched on this a little bit, but in Canada, and I know in the US too, because I've seen you writing on this, there's been a bit of a regulatory push to make private markets more accessible to retail investors. What effect do you think that will have on retail investors? Well, as I said earlier, I think it's just going to reduce the amount of retirement retirement income they have, whether they got a retirement from the Canadian pension plan or whether they, I mean, you know, have their personal savings that they put part of their salary into every month or two, it's just going to hurt their returns a little bit.

1:07:21It's not going to be a lot to notice. As I said, CalPERS, with all their sophistication and complexity, underperforms by about 1.3 % a year. But the average retail person is not going to have the microscope or the magnifying glass and look at all the fine print and see how they did, they're just not going to do it. It's not going to be very noticeable to them, but it is going to hurt their retirement. I tried to point this out at the institutional level with state pension plans and the union trustees and all that. It's hard to look at how they decrease retirees' income, But if the returns on a fund are not so great, then the state can't raise the retirement payments every month.

1:08:05If the returns were great, they could raise them a little more. So it's going to be the same thing for individuals. They won't be able to go out that extra restaurant meal every month because their pension payment would be a little lower. As you can imagine, as a portfolio manager who uses only boring index funds, I do have a lot of clients who are looking for something a little bit more exciting. I think we do a pretty good job of restraining that impulse. But over the years, I've kind of changed my opinion on how much I think people should allow themselves to scratch the itch by going outside of those core holdings.

1:08:42And I'm interested in what you feel like. I don't invest money for people. I was an investment banker. So I was doing mergers and acquisitions and IPOs and private loans and all that. But I've had a lot of people ask me about that with the exact same thing. And just your average person, as I said, wants to dip their toe in the water of private equity or private credit because it just sounds sexy. I was working with some lawyer. He read all my stuff. And we were working on some complicated case where I had to write a paper about private equity as it had to do with this particular deal. And he was curious about it.

1:09:15Finally, he emailed me a couple months ago. He said, yeah, I just bought into a private credit fund. He knew all the dangers, but he just thought he had to pull the trigger on one or two of them. So I don't think it was a huge part of his retirement account, but it could have been a hundred thousand or something. Yeah. I usually try to tell people if you can keep it to 5%, please do whatever dollar amount that happens to be. But I feel like that's probably enough to make you feel like you're doing something a little more exciting. And even if it were to go completely belly up, probably wouldn't cripple you.

1:09:49It's not going to go completely belly up. It's just not going to happen. The worst private equity fund I've ever looked at, maybe 50, 60 cents on the dollar. Even a private credit fund, the private credit funds are going to be a little more diversified. They're senior loans. So in the case of a few bankruptcies, they're probably going to pay out 60, 70 cents on the dollar. The real, I guess, concern one might have is that a lot of these funds, both private equity, private credit, private real estate, they borrow money on top of the money that the portfolio companies borrow. So if I was in your shoes and some of my clients, rightly so, said we want to try something a little more exotic, I guess that's the thing I would look at.

1:10:32I would look at, okay, so jump into the swimming pool and buy a private credit fund or private equity fund. But first, let's see what the governance rules say. How much can they borrow on top of the borrowing? That's all. Yeah, it's not quite the same as taking a flyer on a penny stock or something that could easily go to zero. It's a little more conservative. I mean, the governments, at least the United States, the Federal Reserve and the SEC, I guess, express some concern about the loans that the banking industry has made on top of these funds. So there some pearl clutching in Washington and New York, but there's no real action.

1:11:07There's just not a lot of data on it. But if you look at marketing documents, you'll see a lot of these funds have debt on top of that. I mean, it's true for the real estate example I gave earlier, those Canadian funds, some of them are now gated or locked up. They're still, the assets are fine. They're just not worth as much as the reported net asset value was. Everybody who's following this, and I assume that's a lot of your listeners, they know that But these business development companies or BDCs or these REITs, they're trading at 80 or 85 % of their debt asset value, their claim value. And that just reflects partially illiquidity and partially, I guess, investors' belief that the net asset values are just wrong, that they're inflated.

1:11:53Yeah, that's interesting. All right, Jeff, this has been a great conversation. We have one final question for you. How do you define success in your life? My definition of success is you want to have a decent career. I've done a lot of different things internationally, domestically. I've written books, professor, investment banker, private credit, private equity investor. So for me, I've had a decent career. I've also had a good family life. I've been married to the same woman for 39 years. And I have a couple of kids. One of them will have the engagement party tomorrow, by the way. Nice. Congrats.

1:12:24I do want to leave making this world a better place. So I do a lot of pro bono work. I've done other things besides preaching against private equity and private credit and so on. You know, I think that's important to do. I do it usually for nothing. I do it for free as a public service. But I've done other things along public service lines that tend to have some relation to my financial background. So that's been kind of rewarding. It's also something unusual in Wall Street people that they do sort of this kind of pro bono work. But it's been very interesting. So those are the three legs of the stool that I like to think about when I go over what I've been up to.

1:13:05Very nice. And I can tell you that we and our listeners very much appreciate you coming on this podcast to talk about private equity stuff and private credit. It's been my pleasure. Thanks, fellas. Thank you. Thanks, Jeff.

1:13:19Jeff Hooke:Hey, everyone. It's producer Matt. Thank you so much for tuning in to this week's episode. Before we sign off, here's the disclaimer you've been waiting for. Portfolio management and brokerage services in Canada are offered exclusively by PWL Capital, which is regulated by the Canadian Investment Regulatory Organization and is a member of the Canadian Investor Protection Fund. Investment advisory services in the United States of America are offered exclusively by One Digital Investment Advisors, LLC. One Digital and PWL Capital are affiliated entities, and they mostly get on really well with each other.

1:13:52Jeff Hooke:However, each company has financial responsibility for only its own products and services. Nothing herein constitutes an offer or solicitation to buy or sell any security. Occasionally, we tell you not to buy crappy investments in the first place, but that's not the same thing as telling you to sell them. This communication is distributed for informational purposes only. The information contained herein has been derived from sources believed to be truthy, but not necessarily accurate. We really do try, but we can't make any guarantees. Even if nothing we say is fundamentally wrong, it might not be the whole story.

1:14:27Jeff Hooke:Furthermore, nothing herein should be construed as investment, tax, or legal advice. Even though we call the podcast your weekly reality check on sensible investing and financial decision-making, you shouldn't rely on us when making actual decisions, only hypothetical ones. Different types of investments and investment strategies have varying degrees of risk and are not suitable for all investors. You should consult with a professional advisor to see how the information contained herein may apply to your individual circumstances. It might not apply at all. Honestly, you can probably ignore most of it.

1:14:59Jeff Hooke:All market indices discussed are unmanaged, do not incur management fees, and cannot be invested indirectly. Which is a shame, because it would be awesome if you could. All investing involves risk of loss, including loss of money, loss of sleep, loss of hair, and loss of reputation. Nothing herein should be construed as a guarantee of any specific outcome or profit. Past performance is not indicative of or a guarantee of future results. If it were, it would be much easier to be a Leafs fan. All statements and opinions presented herein are those of the individual hosts and or guests, and are current only as of this communication's original publication date.

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