Ed D’Agostino:
Hi, I’m Ed D'Agostino and I just interviewed my friend, Jared Dillian about his thoughts on private equity. He asked that I share a special version of the discussion with you.
Jared’s research has led him to call private equity, “The Next Big Short.” And he thinks investors who get ready now could be on the winning side of this idea. Here’s my interview with Jared Dillian.
Hey, Jared. It's good to see you. We are here to talk about private equity, which is something you've been writing a lot about, and I want to walk through your entire thesis today about private equity, both the risks and the opportunities because they're both big, but to make sure we don't lose anybody right off the bat, can we just start out with the basics? What is private equity, basically?
Jared Dillian:
Okay. It sounds complicated, but it's actually very simple. So you have public companies, which are listed on a stock exchange, and private companies, which are private and you can't buy them. So something like a mutual fund is an investment company that buys up a bunch of stocks, builds a portfolio of stocks, and holds them over time, passively.
A private equity fund buys up a bunch of private companies and holds them as a portfolio, but doesn't really hold them passively. They're actively involved in management, and what they try to do is get rid of inefficiencies and increase profitability. And over a period of about three or five years, they will eventually, hopefully sell those private companies in an IPO or to another firm at a higher valuation. So that's basically how it works.
Ed D’Agostino:
Or at least that's how it used to work.
Jared Dillian:
That's how it's supposed to work.
Ed D’Agostino:
Exactly. Exactly. Some of these companies are pretty big, right? Some of them are probably household names, especially if you're interested in investing and finance. Can you run through maybe some examples of private equity groups?
Jared Dillian:
Oh, private equity groups. Sure. Blackstone is the biggest. I want to say they have like 180 billion market cap or something like that. KKR is big. TPG, Apollo. I would say those are the big four. And then you have some other ones that focus on private credit, which are a little smaller, like Ares, but those are publicly traded private equity firms. The vast majority of them are not.
The vast majority of them are closely held, and as I've said before, there are 17,000 private equity firms in the United States, and the vast majority of them have less than 1 billion under management. So they're pretty small, but altogether the entire industry has trillions under management.
Ed D’Agostino:
So going back early into my career 25 years ago, I was at a small brokerage and we catered to private equity groups. We did private mergers and acquisitions, and my buyer base was private equity, and they were the smaller private equity groups that you just mentioned. And they were great to work with and the people at these firms are super smart. A lot of them had really deep, specific industry experience.
So if you were looking at a metal manufacturing company and they had people internally that had deep experience in metal manufacturing, and if you were looking at a tech company, that was back in the ISP heyday, they had people in each of these industries that could come and add value to the company and make the company better when they bought it.
And that's what you point out has changed today. The old model was you buy a company if you're a private equity group and you try to improve it and make it bigger, and then you sell it either in an IPO, or for the clients that I worked with, they would sell it to a bigger private equity group or a strategic investor. So somebody that was already in the industry and just wanted to do an add-on acquisition. Can you talk a little bit about what's happened in the last five to 10 years, what that exit strategy now looks like or doesn't look like?
Jared Dillian:
Well, exits have basically gone to zero. The ability to take a company public has been decreased significantly. There really haven't been any IPOs this year. There haven't been IPOs in a while. An IPO used to be a very common exit. You would buy a company when it was private and then you would take it public. That hasn't happened in a long time for reasons really that are unrelated to private equity.
But there's a limited appetite for another firm to buy a private equity owned firm when the valuations are so high because these companies are no longer being bought at four or five times earnings, they're being bought at 10 or 12 times earnings, and to resell them at a higher valuation is almost impossible.
So it's greatly reduced the number of exits available to private equity groups, and as a result, it has resulted in less cash being distributed to shareholders, LPs, and the funds. And that is really the biggest concern. Because if you're an LP, if you're an endowment or something like that and you have 30% of your portfolio in private equity and it's not spitting out in any cash and you don't really know what it's worth, then that's a problem.
Ed D’Agostino:
And it's contributed to what has led private equity to get so big and to start investing in things that maybe they shouldn't be investing in.
Jared Dillian:
Well, I get the impression that private equity has become, and this is really more of a cultural statement, but private equity has become the place to be for young investment banking analysts. Nobody really wants to work at a bank anymore. They want to work at a private equity firm and the pay is better and the hours are better.
So what that's resulted in is people running companies with really no industry experience whatsoever. You used this example, the metals manufacturer, and you had people with experience specific to metals manufacturing. That doesn't really happen anymore. You have a 33-year-old VP who's put in charge of a company, and typically the reflex is they fire a bunch of people, and they raise prices, and that's what they do every single time. That's the formula that private equity uses. They lay off a third of the company, and they raise prices. Everything gets worse.
In the short term, on a three- or five-year basis, you can extract more value out of the company, but really over the long term, you're hurting it. And I think one of the reasons that private equity is failing nowadays is because of this mismatch in time horizon between the founder of the company and a private equity owner.
The founder of the company wants it to be around forever. They want to satisfy customers. They want to keep customers as happy as possible because they plan on being in business forever. The private equity owner doesn't care. They're only going to be in business for three to five years. So they have a different objective, which is to extract as much money out of this business as possible.
Ed D’Agostino:
So that ties in with one of my favorite terms in investing and finance. One of the biggest negative terms in investing is “financial engineering,” and private equity, they are the kings of financial engineering. Let's talk a little bit about how they structure a deal these days because, first and foremost, they use a ton of debt. You said that they're different than your typical owner, the family that started the business, but these guys come in and the first thing they do is they leverage it.
Jared Dillian:
No, that's absolutely true. And I think broadly speaking, there is so much leverage in the world of private equity. The reason you and I are sitting here talking about this today is because of the systemic risks that this poses, and I've called this the “Big Short 2.0.” One of the reasons the Big Short was the Big Short was because of the massive amounts of leverage involved, the massive amounts of debt in the system.
And the same is true of private equity. When a private equity firm buys a company, they typically borrow money to do it. So they borrow a bunch of money, and then there's leverage on top of leverage, and there's just an enormous amount of debt within the system, and that's the problem.
Ed D’Agostino:
So how does a private equity group make money?
Jared Dillian:
Well, they do it a couple of ways. One, they do it in capital gains. So if you can buy a company X and sell it at two, then they have a capital gain. So that's the most obvious way. And two is from income, cash flows of the business and any cash flows that they might have along the way. So those are really the two ways that they do it.
Ed D’Agostino:
So that shines a light on one of the ways that it's different. And what I'm trying to get to is I'm trying to really show people why they should care about this. The everyday person should really care about this problem. One, because it's getting to be big enough that it might actually be a risk to the entire financial system, as you point out. Two, they might work for a company that gets acquired by a private equity group, and they might get fired because that’s what they do, not all of them.
Jared Dillian:
There's actually a number three. And number three is you're the founder and the owner of a company and you're getting close to retirement and you're thinking about selling. And if you sell today, you can sell at a huge valuation, but if you wait three or five years after private equity implodes, then you're going to get half as much money.
Ed D’Agostino:
Right. Exactly. You talked about the exit strategy. They can make capital gains when they buy a company. They fix it up, they improve it, and then they can sell it for more money than they paid: capital gain. That's capitalism. That's a good thing.
But there's a different strategy that they also can take. They can also load the company up with debt. They can extract fees, exorbitant fees from the company while they run it and then once they get to a point where they've reached their target IRR… and I have a story for you about IRR… but their internal rate of return, once they reach that, if the company goes under, they might not care.
They might just let it go under. It would just feel very different than if you and I got together, formed a company, borrowed some money, and bought a business. We would work until our knuckles were bloody to keep that company alive and to keep everyone employed and turn it around and grow it. It's a very different mindset in much of private equity, not all, but much.
Jared Dillian:
And I think that's where that private equity gets the reputation for being vulture capitalism. It gets back to what I was talking about before, the difference between a founder and an owner. There's two completely different objectives. I think Toys R Us, off the top of my head, was an example of a company that was basically allowed to fail. The bonds were trading at par before it went under, but it's absolutely true.
Ed D’Agostino:
Running a business isn't exactly easy. So if you don't have these expertise in general, which I think a lot of private equity does have, but then if you don't on top of that, have the industry expertise, you just treat every company the same and it doesn't work.
It goes to one of the things I've seen you write about, which is that it's such a sexy corner of finance and it seems like there's just riches, like it's easy. It seems easy and everybody's getting into it now. Can you talk a little bit about that because you're the king of sentiment? Where is sentiment with regard to private equity?
Jared Dillian:
That's pretty much where it is. It's a magic money machine, and we can go back in history and look at things that were a magic money machine and see what happened over time. My definition of a bubble is when people are making money out of proportion to their intelligence and work ethic. And look, with 17,000 private equity firms, there's a lot of marginal players. Ultimately, one of the remedies for this, which we'll talk about in a bit, is to short the private equity firms, the publicly traded ones.
But like I said, there's only a handful of them. And to be honest, those are the ones that are probably the best positioned for an industry downturn. If there was a way to short a basket of the small private equity firms, the sub-billion AUM ones, that would really be interesting, but unfortunately, it just doesn't exist.
Ed D’Agostino:
I think you sent me a text once of a picture of Kim Kardashian starting a private equity group.
Jared Dillian:
Kim Kardashian, she's not even the best example because she's actually pretty smart and she sort of knows what she's doing.
Ed D’Agostino:
Probably one of the best marketers in the country.
Jared Dillian:
So that's not the best example. The best example is a guy named Caleb Williams, who is a 23-year-old quarterback for... what team? I forget, maybe the Browns. And he started a private equity firm called 888 Midas. A 23-year-old football player, starting a private equity firm called Midas. It's just...
Ed D’Agostino:
It's that easy.
Jared Dillian:
You see this in every cycle, and the thing about private equity is it is a bubble. It is absolutely a bubble. It's one of the biggest bubbles of all time. But it's hard to communicate that to people because it is opaque and a lot of people don't... Look, I had to explain what it is at the beginning of this call. A lot of people don't know what it is, but it is absolutely a bubble.
Ed D’Agostino:
So why is it a bubble? Is it because they're buying companies that make smoothies, smoothie stands and car washes? And I have a friend who, five or six years ago, he's a funeral director and he had two funeral homes in tiny little towns in rural Vermont, and he was taken out by a private equity group. How does this make sense?
Jared Dillian:
The funny thing is that a funeral home is actually a pretty good business to buy.
Ed D’Agostino:
But for a private equity group?
Jared Dillian:
Well, actually I take that back. I just want to talk about funeral homes for a second because-
Ed D’Agostino:
People are dying to get in?
Jared Dillian:
It's a grave situation. That's a risky business. And I had somebody tell me they bought a cemetery REIT, right?
Ed D’Agostino:
Wow.
Jared Dillian:
They bought a REIT that owns cemeteries, and it turned out to be a complete disaster because over the last 10 or 15 years, everybody is getting cremated. It used to be that 80% of people were just buried, and now 80% of people are cremated, and this guy lost his ass on the cemetery REIT. So you would think that a funeral home has a pretty stable conservative business. There is risk in everything.
Ed D’Agostino:
Agreed. And when you're bidding prices up... So private equity groups, part of how they make their money, if I understand it right, is they charge fees on assets under management.
Jared Dillian:
Yup.
Ed D’Agostino:
So if they have a bunch of cash that they haven't deployed, they can't charge fees on it, and when you add them all together, there's just more money than can possibly be put into the private market at this point, it seems like, without raising prices.
Jared Dillian:
There are not really any good deals left, and there's a huge amount of competition for these deals, and the valuations are going up. And one of the things that I like to talk about with private equity is a lot of this is driven by the demand side. It's driven by the LPs. It's driven by the endowments and the pension funds and the family offices because they have cash they want to put to work. They basically say, "Okay. We have 20% of our portfolio that's going towards private equity." Whereas that used to be zero, but now it's 20 or 30%, and that money goes to private equity no matter what.
And they talk about dry powder in the private equity industry, I think there's like $700 billion of dry powder that hasn't been put to work yet. It's just an enormous amount of money.
Ed D’Agostino:
And if you don't put it to work, if you don't invest it, you have to give it back at some point. And that's a no-no. So it's not a good situation. How do rising interest rates or higher interest rates than what we've had for the past 15 or so years, how does that play into all this?
Jared Dillian:
Well, that's actually a big deal because a lot of these deals that were getting done five years ago in 2019, interest rates were super low back then. So with Fed funds at zero, these private equity firms were borrowing it at like 2.5%, and now they're in a position in 2024 where they have to refinance that debt at 8%, right? That's a big deal.
Ed D’Agostino:
Anyone looking at buying a house right now and calculating how their mortgage payment would change with a 7% mortgage rate is well aware of the impact of mortgage on a payment… or I'm sorry, of interest on a payment.
So you put together an unbelievable presentation where you really make the case really well in an exposé of private equity. It was a 30-page document.
But I want to get into some of the parallels. You mentioned that you’ve been calling this the next Big Short or the Big Short 2.0. There’s a lot of parallels between what’s going on in the private equity market today and where the US economy was maybe back in 2006. Where everything seemed great before the great financial crisis, before the economy melted down because the housing market collapsed and the mortgage industry blew up.
In 2006, very few people, there were some, but very few people were talking about that as a risk. Stock market was going up, people were making money, everyone felt great, and then most people got blindsided in 2008, 2009, stock market collapsed. People lost jobs, millions of people lost their jobs. Businesses closed, economy went into a deep recession.
The financial system almost melted down globally. It was bad, but in 2006, nobody really saw that coming or very few people, and I'm curious if you think that today is the equivalent of 2006 with private equity.
Jared Dillian:
There's a lot of things in common. In both cases risk appetite is enormous. We have huge amounts of risk appetite. Interest rates are also high. Liquidity is abundant. Up until this recent bout of volatility in the stock market, we had an extremely low volatility environment. There's a lot of things in common between '06 and '24.
I will say that I think in 2006, more people were aware of the problem than they are with private equity today. In 2006, there were signs everywhere, there were housing developments that were empty, they were being built in the middle of nowhere. You had these sleazy real estate agents on the cover of Fortune magazine with a cell phone up to their head. It was pretty obvious that there was a bubble.
I don't think it's as obvious today. I think if you're in the financial world and you're on Twitter and you see what I post all the time, then you probably have an inkling that there's a bubble, but I don't think it's common knowledge yet. I think it was common knowledge in 2006, which leads me to believe that we're still probably a bit early.
Ed D’Agostino:
You're very financially savvy and had a long career on Wall Street, and I think you saw some of what was happening. Didn't you go to look at a condo in 2006 in Miami, and the real estate agent was taking a nap in the guest bedroom?
Jared Dillian:
Oh, it was in Hermosa Beach, California. The guy was asleep on the bed.
Ed D’Agostino:
Ding, ding, ding. Top.
Jared Dillian:
That's when people are making money all out of proportion to their intelligence and work ethic. That's a bubble. But it's true with private equity too. I know some private equity people, and they're fine, they're nice people. But they're not... I don't want to say they're masters of the universe. I don't want to say that they should be making 500 grand at the age of 26.
And by the way, when I was working on Wall Street, I was the beneficiary of one of those bubbles. The 2000s, in addition to being the real estate bubble, was also the hedge fund bubble. There were 15,000 different hedge funds. The trading business was enormous. I was 30 years old getting paid almost a million dollars a year. That was transitory, that did not last. And this isn't going to last either.
Ed D’Agostino:
The other cool thing about that whole period, and Michael Lewis outlined it really well in his book, The Big Short, and there was a movie called The Big Short based on the book, but you had guys like Steve Eisman and Michael Burry who made fortunes. They made absolute fortunes by seeing what was coming, figuring out how to invest in it, doing it early, and then just being patient and waiting. Do you think that that opportunity exists now?
Jared Dillian:
Yes, I do. And I want to say it's very, very similar because if you remember, if you watch the movie or read the book, Steve Eisman, Michael Burry, they put these trades on and the housing market started to collapse, and they didn't make any money. You remember that?
Ed D’Agostino:
Yes.
Jared Dillian:
They didn't make any money because the banks kept marking their bonds in the same place, and they were furious. They're like, "How can you mark the bonds here?" But the banks could mark the bonds wherever they wanted to. It's the same thing with private equity.
Just a stupid example, but let's say we get a hypothetical example, stock market goes down 50%, right? The S&P is down 50%. Well, private equity should be marking down their portfolios, but they won't. They can, they can. So it's the same exact scenario. So however long you think this is going to take to play out, it is going to take even longer because they will not mark down their portfolios until they absolutely have to.
Ed D’Agostino:
So those investors, the Eismans and the Burrys of the world that were featured in the movie, they made their money by putting on these exotic trades using derivatives and tools that an individual investor's not going to be able to avail themselves of, like credit default swaps, stuff that no one had ever of before, unless you were a structured finance guy on Wall Street. Is this the same type of situation for an investor who knows about the risks of private equity? Can they put this on? Can an individual put it on?
Jared Dillian:
You can. The answer is yes, you can. You are limited to listed securities, right? So the publicly traded private equity firms, you can trade options on them, which comes in handy. And there might be some derivative plays, which I haven't really figured out yet. I'm in search of derivative plays on this, there might be some, but the answer is yes, as a individual investor, you can play this.
Ed D’Agostino:
Okay. And how do you think about this in terms of size? A guy like Michael Burry, I didn't see his book, but I'm assuming a big percentage of his fund was invested in the idea of real estate collapsing. Is that how you're looking at this, or is this a risk a little to make a lot, type opportunity?
Jared Dillian:
It all depends how you structure it. The nice thing about private equity is that I think the distribution is not normal. I don't think private equity has a lot of upside from here, let's put it that way. I've been short one of the stocks for eight months, and I'm down like 5% on it. There's not much in the way of upside, which enables you to size it a little bit bigger. You can size it bigger than you normally would. And if you're running a long, short portfolio, if your longs are going up and your shorts are staying unch, then you're pretty happy, then that's actually a win.
Ed D’Agostino:
So I've heard you say many times, and right before the market correction that we had a few weeks ago, you told your Street Freak readers to buy some puts on the SPY, on the S&P 500, because your logic was, "Look, things are looking a little toppy and you need to buy insurance when you can, not when you need it, because when you need it, it's too late." Is this a similar situation where you do it now while you can and then you wait?
Jared Dillian:
Well, I think that's true of all situations. I think that's true anytime you're going to put on a short. The thing is that these stocks do pay dividends so there is some negative carry. If you're buying puts, then if there's a clock ticking, so if the stocks don't go down, you're losing money. So basically, it's the same situation with any short, you're like, "How do I be short in pay as little amount of carry as possible?" That's the challenge. You remember in 2014 when I was shorting the Canadian banks, right?
Ed D’Agostino:
Yes, I do.
Jared Dillian:
Okay. So I was short CIBC for five or six years, and over five or six years, the stock was unch, I actually broke even, but I paid $250,000 in dividends. There's a cost associated with being short, you have to pay the carry.
Ed D’Agostino:
But if I recall, that short the Canadian housing trade ended up being profitable for you overall.
Jared Dillian:
Yes.
Ed D’Agostino:
So even though you didn't get the spectacular meltdown that you, I think, were thinking might happen, you made money on the idea because you knew how to do it.
So that's really what I want, to wrap this up as if you're a Wall Street trader, if you're a market participant listening to this conversation, you're intrigued by the idea, you see all this sort of same things that Jared sees, well, you probably know what to do or you have a research shop that you could go to and say, "Look at this."
For an individual investor or somebody who doesn't have access to that level of research, this is what you do, it's Street Freak, you are going to hold people's hands and tell them, "This is exactly what you need to do. Here's how you do it. If you've never done a short, here's how you do it. If you've never bought an option, here's how you buy it, here's which one you buy." You'll do all of that for them and help them put this idea to work. Correct?
Jared Dillian:
Yup. For sure.
Ed D’Agostino:
Cool. So we'll make sure that we get anyone who's interested more information on Street Freak because you've got a special offer coming and you're orienting that letter around this Big Short 2.0 idea, which I think is spectacular. It's about time more people start making money on Wall Street shenanigans instead of getting wrenched by it.
Jared Dillian:
Well, the other thing I'll add is in Street Freak, there's a portfolio and there's a bunch of longs and there's a bunch of shorts, and the portfolio is done very well. We know the returns, it's done very well. I think that short private equity is a good trade on a standalone basis, but I think it's an even better trade in the context of a bigger portfolio because of the risk characteristics of those private equity firms. So that's one of the reasons why I like it so much. It's just the perfect hedge to a portfolio.
Ed D’Agostino:
Nice. Okay. Well, Jared, thank you. You know what? Before we go, I just got to ask you. You were on Wall Street, you were at Lehman Brothers, not just on Wall Street, but at Lehman Brothers during the financial crisis. Hopefully I don't trigger bad memories for you, but you had nothing to do with the real estate department. You were head of the ETF desk and you grew that desk to be one of the biggest on Wall Street while you were there. What was it like? What was it like for you on both the good side and the bad side?
Jared Dillian:
Well, I can tell you that I knew that Lehman was going to go bankrupt. Not just me, but everybody at the firm. We knew there was a problem. The stock topped out in the summer of '07. And then it just had the ugliest chart of any stock in history. It could not get an uptick. Literally, the stock could not get an uptick for year and a half.
And in the summer of '08, my wife was in Kenya doing research, and the stock was trading around 15 or 20 bucks. And I was like, "We are definitely going bankrupt." And she got off the plane when she came home, and I'm like, "I'm going to need to find a job." So that was in July of '08. So we knew it was going to happen. And then there was all this stuff, like Dick Fuld was trying to sell the firm to the Korean Development Bank and all this crazy stuff. And I pretty much knew for about three to six months that it was going to be over.
Ed D’Agostino:
Okay. And did you see any of this sort of Michael Burry side of things?
Jared Dillian:
Our client base was predominantly hedge funds, and we would go out for drinks with them, and they would tell us to our face. They're like, "You guys are going bankrupt. It's happening." And they wouldn't short Lehman at Lehman because we were restricted in Lehman we couldn't trade Lehman, but they would short Lehman at Morgan Stanley, and then we would hear from people at Morgan Stanley that they were shorting our stock.
Ed D’Agostino:
Your customers?
Jared Dillian:
Our customers. It was a very consensus short, all the hedge funds were short Lehman, and I got to say, it was one of the few shorts that actually went to zero. Most shorts don't go to zero, right? They go now 90%, and they stop, and then there's a squeeze, and everybody gets sconed, like Beyond Meat, most recently, everybody thought Beyond Meat was going out of business, and they burned a bunch of short sellers. GameStop, companies don't go to zero, but Lehman was the one that went to zero, and all these short sellers got paid off.
Ed D’Agostino:
So you’ve got to know when to get out, in general.
Jared Dillian:
Yeah, in general.
Ed D’Agostino:
Well, I'm excited about this idea. I've had the good fortune of working with a lot of private equity folks over the course of my career. I've interviewed some, David Rubenstein. There are some fantastic people in private equity. They're not all bad. It's just that the industry as a whole has gotten too big, way too big. And there's so many distortions now that I think it's a great idea. What do you think is going to set it in motion?
Jared Dillian:
That is the part that I don't know. I really have no idea. It'll be a surprise. It'll be a surprise.
Ed D’Agostino:
Okay. So put the trade on and wait.
Jared Dillian:
Yup.
Ed D’Agostino:
All right well, we’ll get some more information out on Street Freak, where you can learn everything, the specific details on how Jared is doing it and do it along with him.
Thanks for watching Jared and me discuss this opportunity in private equity. Like we said, if you want to know exactly how to invest in this idea, be on the lookout for an email from Jared next week. He’ll have a special offer for you for his Street Freak investment letter where you can follow his latest ideas on the next Big Short.
You’ll also receive an invitation to join a live monthly call with Jared for updates on private equity, and he’ll answer any questions you might have about the entire Street Freak portfolio.
I hope you found this helpful, thanks for tuning in.