Ted Seides is the founder of Capital Allocators and former president of Protégé Partners.
On a late summer day 18 years ago, I began communicating with Warren Buffett about a bet that pited the hedge fund’s performance against the S&P 500.
This proposal became a bet for a decade of charity from January 1, 2008 to December 31, 2017. It seemed good for hedge funds in the early years surrounding the global financial crisis, but the market has since recovered strongly. By the time of Berkshire Hathaway’s 2016 Annual Report, Buffett had been able to take the victory lap.
There are a lot of virtual ink spilling around the meaning of bets. Warren initially assessed the probability of winning at 60% (but wrote in his 2016 annual letter as if victory was pre-determined). I initially called it at 85% in our favor. There could have been a lot of results, but only one did. Looking back, I was overconfident, but those who read too much of the results warn me.
Annie Duke calls this “consequences.” This is a behavioral bias that determines the quality of decisions based on outcomes, not the decision-making process itself. They are likely in favour of hedge funds at the time, and believe that the unprecedented actions by the Fed have bailed out the market from a lost decade.
Regardless of cause and effect, bets led to unexpected connections, relationships, and experiences. Warren and I met up for dinner almost every year, and usually had a guest or two. These guests included Todd Combs. Ted Weschler; my partner at the time and is now Secretary of the Treasury, Scott Bescent. Bobby Jane, founder of the hedge fund. Podcast star Patrick O’Shafsey. Permanent Equity founder Brent Beshore and investor Steve Gal Blace – Warren was directly led in honor of Steve’s best friend Jack Bogle at the 2017 Berkshire annual meeting.
Most importantly, with Warren’s victory, Omaha’s Joshisha received over $2 million and purchased a protégé home to provide housing support and guidance to Joshisha alumni. The growth of the $1 million bet to $2 million in revenue is a story in itself. Initially, they split the purchase of zero coupon bonds that matured for $1 million over a decade. After the Fed lowered interest rates to zero, its $640,000 spending rose by about 50%. Just before Warren bought back the shares for the first time, he decided to sell the bonds and buy Berkshire Hathaway stock. BET’s collateral performance far outperformed both the S&P 500 and the hedge fund.
Since then, many others have naturally reached out to me and proposed many different bets.
Bitcoin Hodlers, Chinaables, the average reverter in emerging markets, and Japanese governance reformers, all of whom were convicted. I’m not sure if they communicated with Warren, but I didn’t see any related comparisons for any of them.
But a few weeks ago I came up with another bet that is equal or greater importance to the first one. What bets do you ask? Private Equity and S&P 500.
Comparing a portfolio of North American acquisitions with the S&P 500 has important results as private equity seeks to enter wealth management and access pension plans. In fact, they argue that this matchup will help shed light on one of the most troublesome and controversial debates in finance today.
I think you know what Warren thinks. High fees and additional costs destiny for private equity investors. It is possible that many external factors influenced the outcome of our first bet (I wrote about it here), but that is unlikely to happen in this comparison. This bet is much closer to faithful expression of Warren’s original premise. That bet is an intellectual expert with strong financial incentives to overcome the high fees you charge.
The S&P 500 and North American acquisitions provide a diverse exposure to the US economy. Public and private market firms are similarly affected by macroeconomic variables and are exposed to a common geographical and sector. (While the MAG 7 controls the S&P 500, software and technology are the most representative sectors of acquisitions.) Because transactions between the two markets can mediate large pricing inconsistencies, its pricing (equities and buyout EV/EBITDA) is correlated.
The question is whether those differences are sufficient to compensate for the costs of private equity doing business. Leverage, size, dispersion, illiquidity, and control of each – in theory it has a positive effect on private equity returns compared to the S&P 500.
– Leverage: The S&P 500 is about 0.6 times more debt. Private equity is 1.5 times more. Assuming 10 years of positive returns and ROA above capital costs, leverage increases private equity returns compared to the market.
– Size: Private equity-owned businesses are smaller than S&P 500 businesses. Historically, small businesses have outperformed larger companies, but that has not been true for a while.
– Diversification: The variance in returns across private equity managers is much broader than that of the public stock market. This creates opportunities to outperform within the asset class.
– Il-liquidity: By design, private equity is illiquid. Illiquidity may not directly affect returns, but it can help investors avoid reaching them in their own way. Darvar’s quantitative analysis of investor behavior consistently shows that investors in the national market are getting much lower returns than the investment itself.
– Control: Private equity companies are the management owners of the company and compensate for management teams tailored to the outcome. Public companies tend to have less shareholder involvement and less management ownership.
Put the numbers on these concepts: Assuming a 10% return on the S&P 500 over a decade, private equity should provide a total revenue of around 15% to win the index. Higher leverage can compensate for 2-3 percent points of that gap with current interest rates and spreads. However, the 40-year tailwind of lower interest rates will no longer support private market returns as in the past.
Second, small and medium-sized businesses can grow faster than large companies. This is a factor that can benefit the private market over time. Over the last century, US small caps have outperformed about 1.5% per year, but its premium has been slightly negative since GFC.
Together, the structural benefits of private equity could probably account for 80% of the gap. The rest is up to the top private equity manager, allocators to choose a private equity company to make above average investments.
In my book, Private Equity Transactions, I explained 12 examples of private equity transactions. These managers have many tools at their disposal to create value. When reading their stories, it’s hard to imagine that they won’t find a way to tell them.
But as we learned from our bets with Warren, the future is much more difficult to predict than the past. When you add it, I’m over the odds of private equity, the S&P 500 fees at around 40%.
Over the next few months, we’ll be talking to podcast guests to see if we can identify investable options representing North American acquisitions, and if anyone takes both sides of the bet.
Starting January 1st, you might find it fun to create a Shadow Wager and report on your results every year over the next 10 years. This time we’re even more excited to see if unexpected benefits and connections emerge.
So. . . What do you think?
