Investments that may have hit their peak

New York

LAST week was the 10th anniversary of the collapse of Lehman Bros, a flashpoint in the financial crisis. The economy has rebounded since then and the stock market has risen to record highs, but a feeling of caution looms over many investors.

One of them is Dan Rasmussen, a contrarian investor who has marshalled data and historical returns to argue that three of the most popular asset classes for high-net-worth investors are not as desirable as they seem.

Mr Rasmussen, founding partner of Verdad Capital in Boston, has written an article and two reports that make a case against investments in private equity, venture capital and private real estate, and he has piles of data to back up his argument.

"I want to give the advisers the intellectual ammunition to allow them to say: 'No, I'm not going to put money into these strategies,'" he said.

But some advisers challenge this point of view, saying it is almost akin to market timing. "You could look at any asset class at any point in time and position it in a way and understand why it's outperformed or underperformed," said Scott Stackman, managing director of private wealth at UBS Wealth Management.

Here is Mr Rasmussen's argument for caution in three areas:

A model past its prime

During the financial crisis, Mr Rasmussen worked at Bain Capital, a leading name in private equity. One of his jobs was to collect data on deals by Bain and its competitors to determine why some had done well and others had not.

The more profitable deals were the least expensive ones, he found. The cheapest 25 per cent of deals accounted for 60 per cent of the funds' profits. The top 50 per cent accounted for just 7 per cent of profits.

The difference was the price paid for the company. This was not solely for the obvious reason that paying less is better, but because private equity funds typically borrow 60 per cent of the purchase price, which affects a company's profitability.

Mr Rasmussen said he admired the success Bain had in the 1980s and 1990s, but began to question whether the private equity model it had helped pioneer was still sustainable.

When early private equity firms bought relatively small companies at a discount and loaded them up with debt, the amount of leverage on the company was still about four times the company's earnings before interest, taxes, depreciation and amortisation, a measure of profitability known as Ebitda.

Private equity firms continued to apply this strategy, but they were paying more for the companies, and consequently the amount of debt was rising to more than six or seven times Ebitda. With leverage at 10 times Ebitda, Mr Rasmussen found, a company's free cash was almost all going toward debt service, and it was nearly impossible to be profitable.

A recent example is Toys R Us, which Bain, KKR and Vornado Realty Trust acquired for US$6.6 billion in 2005. When it filed for bankruptcy in 2017, the toy company said it had US$5.3 billion in debt and was paying US$400 million in annual debt service payments.

Mr Rasmussen said the sector would look worse if not for a few high-performing funds that pulled up overall returns.

"It's probably the worst time ever to invest in private equity," he said. "And now, it's being packaged for wealth management firms and registered investment advisers."

According to PitchBook Benchmarks, which gathers data on private equity investments, only 25 per cent of funds have been outperforming the market, and have done so by a smaller amount.

Mr Stackman of UBS said he was still putting money into private equity and hedge funds for certain clients, and reducing their investments in public equities or fixed income. "I don't know if I'd term it as a true shift," he added. "This is our belief in how the high-net-worth clients could and should be invested."

Mr Rasmussen said the funds that still provided high returns equal with the risk were generally smaller ones that acted more like the owners of the companies they bought and didn't just add debt to increase returns.

An inconsistent pattern

The argument against venture capital is less nuanced. Top private equity funds are still delivering high returns, but venture capital funds have largely functioned as what Mr Rasmussen calls "a rich man's lottery".

He cites data from Cambridge Associates showing that venture capital has underperformed the S&P 500, the Russell 2000 Index and the Nasdaq over the last 15 years. And he argues that those venture capital firms that built big names often did so with a few spectacular investments that overshadowed more mediocre ones.

The venture capital firm Benchmark, for example, invested US$6.7 million in eBay in 1997. That investment grew to US$5 billion in two years, outshining other investments.

Any venture capitalist will argue that the big winners make up for all the bets that did not pay off. Mr Rasmussen does not dispute that; he emphasises how difficult it is to find those funds that are going to consistently make the big winning investments.

Higher fees mean lower returns

Mr Rasmussen draws a distinction between real estate owned by private equity firms and real estate investment trusts (Reits). And for him, the difference in returns comes down to fees. A Reit typically charges a management fee of less than one per cent. A fund that owns real estate will charge a typical private equity fee, which can be as high as 2 per cent to manage the money and 20 per cent of the profits.

"By and large, it's a pretty efficient asset class, since rental income is a fixed contract," he said. So fees play a big role in the difference in returns.

But real estate owned in Reits, he said, could be a good buffer for anxious investors because they have a low correlation to traditional equities given their stream of rental income. They're also less risky, he wrote, than his focus, small-cap stocks.

Another view

Excluding entire asset classes can be a tough sell, some financial advisers say. Investors should be asking instead whether an asset class is performing as it should.

"You could put together a low-volatility portfolio of hedge funds, and they will get very consistent return," Mr Stackman of UBS said. "But you're not getting the generous returns the S&P has been giving you since 2009."

That would be around 2 per cent a year for hedge funds versus about 18 per cent for the S&P 500. And many asset classes now have had a good run. NYTIMES