Today, we’re chatting with Daniel Rasmussen, a founding partner at Verdad Advisors.

Daniel was a member of Forbes 30 under 30 at Forbes. His fund aims to replicate private equity returns in the public markets by using research and quantitative methods to build a portfolio of leveraged companies. He has also written extensively on the subject. Before starting Verdad, he worked at Bain Capital and Bridgewater Associates. He graduated from Harvard summa cum laude and Phi Beta Kappa and received an MBA from the Stanford Graduate School of Business.

Tim Melvin: Your firm is doing what you call “private equity replication.” Can you explain how that works?

Daniel Rasmussen: I think three key quantitative characteristics mark or differentiate private equity deals from public equity.

Those three are size, leverage, and value.

The average PE deal is about $180 million of market cap. The average S&P 500 constituent is over $30 billion of market cap. These are tiny, tiny little companies, the vast majority are equivalent to public micro-caps. Private equity is a micro-cap asset class.

Second, private equity deals are about 65% levered, and I’ll net that to enterprise value basis. In contrast, the Russell 2000 constituents are 10% levered, and S&P 500 constituents are about 10% levered, so a lot more debt.

And then third is valuation.

From about 1980 until 2006, private equity was fine. Companies had a 30% to 40% discount to where the S&P 500 traded. Since then, it’s become, even on a gap basis, priced significantly higher than the S&P.

My argument is that relative returns — comparing private equity to public markets — were much better when the valuations were lower. If you look on a deal-by-deal basis, the cheaper deals explain a disproportionate share of the industry’s profits. So what you want to do is buy small, cheap, levered companies, and that is the old private equity strategy.

What private equity is doing today is buying small, expensive companies with a lot of debt. Pay attention to credit quality and credit ratings. As purchase prices and leverage levels increase, the bankruptcy risk also increases. Unfortunately, I think current private equity is paying such high prices that the banker is seeing default risk of what they’re creating in these deals outweighs the benefits of financial leverage.

Tim: But isn’t the current environment similar to say 2005 or 2006? I remember having similar discussions with people on this issue.

Daniel: It’s actually much worse.

In 2008, private equity was paying at the peak roughly 12.6 times EBITDA. In 2006 and 2007, they averaged about ten times. Let’s say, for those three years, they were averaging about 11 times EBITDA.

We’ve been over that level since 2016. What’s even scarier is that not only are we closer to 12 today, but that 12 is not adjusted to EBITDA, and EBITDA adjustments have massively increased.

Now about 25% of that EBITDA is based on adjustments. On an unadjusted basis, P.E. is probably paying 15- or 16-times EBITDA. In terms of leveraged levels, they’re probably between 7- and 8-times EBITDA. So we’re looking at really, really expensive, pretty scarily-priced, levered deals.

Tim: A few years ago, Leon Black of Apollo said that most of his firm’s success was because their average deal was done at 6 times EBITDA.

Daniel: Yes, and Apollo is the most value-oriented of the LBO shops. I think he’s understood that from the beginning, and you can see that in his returns. This [philosophy] is what’s driven Apollo’s success.

Tim: Going back to the private equity replication strategy, if an investor is going to use that type of strategy, what kind of annual returns using the old-school private equity metrics do you think they could anticipate?

Daniel: It depends on what you’re buying.

I’d say, mid-teens [percentage return] would be my best bet in this pricing environment in the United States. I think if you’re willing to go to Europe or Japan, it’s probably low 20s.

I think those markets are a lot cheaper and more attractive. You could say, “Well, treasuries are at 2%, the equity risk premium is at 4%, so that gets us to a 6% return on a forward basis for U.S. equities.”

And then you’d say, “P.E.’s historical performance of public markets over long periods is about 6%.”

That gets you to about 12%. But they were taking that 6% in fees. You can’t forget the fees. Depending on what fees you pay in the U.S., somewhere between 12% and an 18% [performance fee] seems reasonable.

Tim: Now, in your opinion, is this something that an individual could use on their own at home?

Daniel: Yes, I think so. I think that for those that like micro-caps and are willing to invest in them and understand how volatile they can be, then I think there’s absolutely space for people to do this at home.

You want to buy small.

Look at the universe of small and micro-cap U.S. stocks. You then say, “Okay, I want to look at the ones that are pretty cheap.”

So, let’s say have a maximum EBITDA multiple of about 7 or 8 times, so they look like the best-performing PE deals. Then PE leverage on a deal like that would be about 3 times net that to EBITDA.

So somewhere in the 3 to 4 times. And then the other thing is you want to make sure they’re not going to go bankrupt.

Now, that means that make sure that you’re buying ones that are profitable, cashflow-generative, not heavily shorted, not triple C rated, and avoid other typical landmines. That [combination] will produce a portfolio that looks a lot like the 1980s’ or 1990s’ LBO portfolio.

Tim: Now, would you say these opportunities exist right now around in the United States?

Daniel: I’d say there are probably 50 to 100 that fit in the sweet spot of those quantitative metrics I described.

Tim: You and I spoke in Orlando a few months ago. Since then, you’ve had some things to say about the credit quality in the leveraged loan and high-yield markets. How do you feel about those markets today?

Daniel: What’s really worrisome, and you can play it back over time, but start with the old school in the 1970s, ’80s, ’90s. Most of the commercial, industrial lending was done by banks. They had relatively strict credit standards that were learned through hard experience.

Then Milken introduced the high-yield bonds, and the high-yield bonds started by taking the stuff that the banks wouldn’t lend to, or putting leverage levels that were too high, that the banks considered too risky, right?

Then that market sort of grew and really peaked in probably the late ’90s or early 2000s.

Since then, we’ve seen the rise of private credit and CLOs and BDCs. Now private credit is doing to high-yield what high-yield did to banks.

They’re taking the issuers that are too risky or want more leverage than a high-yield bond issuance would permit.

They have rapidly grown, and they’ve grown by working very close to the private equity firms to put even more debt at even lower quality under these companies. You’ve got this new set of lenders that are lending what I would consider crazy, risky amounts to crazy, risky borrowers.

That’s what’s really funding the private equity boom.

The private credit and private equity boom are operating together in that these private lending markets are what’s enabling these crazy purchase prices, these crazy EBITDA adjustments, these crazy uni-tranche leverage facilities.

As a result, if you look at the credit quality of PE, the credit quality has really deteriorated to the point where I’d say 98% is single B or below.

Probably a good 20% is CCCs. And what’s truly even more shocking than that, is that I did a survey of institutional investors, and over 70% of them thought that the average credit quality of private equities was B.B. or above. They have no idea of the credit quality of what they’re investing in, and just how bad it is.

Tim: You mentioned Business Development Companies They are very popular with individual investors right now because of their high yields. Are folks potentially buying into a time bomb with BDCs?

Daniel: High-yield is an asset class that is constantly disappointing people. It’s constantly disappointing because the yield you get when you buy it, it’s never the return you realize, because of defaults and downgrades.

BDC lending is generally at a lower quality than high-yield, so the gap between the yields and the actual returns are actually even worse. What you’ve seen, if you go back to say, ’04, you’ve seen yields on BDCs that were right around 10% over that period, and they’ve delivered returns of about 6%. So obviously, you see a deterioration of credit quality. That’s a return that pretty much lines up with single B high-yield bonds.

You get the same return as buying BDCs by buying single-B bonds, but much lower volatility. More recently, there has been a pretty good run for the BDCs. Since 2010 BDCs have tended to yield about 10%, they’ve returned about 7%, which is right around where B.B. bonds have returned.

But B.B. bonds, which also delivered about a 7% return, at a max drawdown of 5% over the last ten years, BDCs at a 27% drawdown. I would say that the yield you’re getting on the BDCs is not going to translate to returns. You’re better off buying high-yield bonds, B.B.s or Bs would approximate the credit quality of what’s in the BDCs.

Tim: Are there any specific industries in the U.S. or sectors where you say: “There’s a lot of private equity replication opportunity here?”

Daniel: I think that you have to start with what’s cheap in the U.S., which is not much. I’d say what’s cheap in the U.S. tends to be in the industrial sector. There’s also a lot of cheap stuff in the energy sector, but a lot of it carries high bankruptcy risk.

I’d say the sweet spot in the U.S. today is in industrials, I’d say retail is similar to energy, a lot of cheap leveraged retail companies, but a lot of bankruptcies. I’d say the sort of sweet spot is in the cyclical industrial realm.

Tim: I would think that ranking the credit on these is an important part of this process because if you could take out the bankruptcy risk, that’s going to make your returns higher.

Daniel: That’s right, so you eliminate the stuff that’s essentially CCC rated. I would say for a company, if it’s in sort of micro-cap land, if it’s got more than say 4 times net debt-to-EBITDA, that’s too risky. You really want less than 4 times net debt-to-EBITDA.

Tim: Where else do you see opportunity in the world?

Daniel: Valuations are much more attractive outside of the United States. I think a few big pockets of opportunity exist today. One that’s always a big pocket for value investors is the country of Japan, and Japan is doing well.

You’ve got Abenomics kicking in, and yet, Japanese equities are priced at March of 2009 levels.

It’s really, really dirt-cheap. Part of that is concern over the trade war, part of that is aging demographics. Some of that is just years and years of investor neglect that people are just terrified of Japan. Then part of that is the reality that Japanese managers are terrible capital allocators.

Japanese equity shouldn’t trade at the same multiples as the U.S. There’s a risk as to what the CEOs will do. But they should trade at [levels] closer to U.S. equities than they do today. I think that’s a great pocket of opportunity. Obviously, the language barrier’s difficult. I think that keeps a lot of people out.

The next pocket of opportunity is in Europe. I would divide Europe into four parts, and I think three of them are attractive, although for different reasons.

Let’s say the U.K., which I guess is one part of Europe, or maybe it’s not part of Europe they’re still deciding. But the U.K. is very attractive, lots of small companies. It’s cheap because of fears about Brexit, and the pound is cheap, so you’ve got a lot of opportunities in the U.K. If you’re an English speaker, you can read the financials. So that’s a great market.

The next is the PIGS, so Portugal, Italy, Greece, and Spain. Value investors do best in times of economic crisis. And when economies rebound, those value stocks rebound more. So if you’re a value investor, you’ll want to be thinking where are there economic crises that could mean revert so I can really make a big value premium?

That’s nowhere truer today than those PIGS countries where unemployment is high, or growth is slow, and any change in macroeconomic circumstance gets really good for value stocks in those places, so that’s a great market.

And then you’ve got Eastern Europe, which is if you’re willing to venture into Russia, Poland, things are super, super scary for people, I think, for obvious political reasons.

Then finally, there’s the sort of core Europe, Scandinavia, Germany, France. I don’t find that that’s attractive. There are not that many value stocks there. I would say the U.K. and Italy are really attractive in Europe.

Tim: Do you look at all at the emerging markets in Latin America or the African continent?

Daniel: I don’t, and I’m pretty risk-seeking. But the one thing risk I don’t like is the governments could just write rules, steal money, or lock up capital. Maybe I should be more adventuresome. Other than dabbling a little bit in Russia, I pretty much steer clear of the emerging markets.

Tim: Now, the big topic: China. Do you see any opportunities to do anything in the country?

Daniel: Maybe this is my bias, and I should get over this. But I do not know what equity is in a Communist country. What is ownership in a country where the government owns everything? I don’t know. I’d stay away from it.

Tim: We’re in complete agreement on that. Years ago, there was a bunch of Chinese net-net stocks around trading below alleged net current asset value, and those have done well everywhere in the world forever, except in China because they sort of made up numbers and put them on the balance sheet. That was my one-and-only attempt in China.

Daniel: If you want net-net, there are a ton of net-nets in Japan.

Tim: Japanese regional banks are just stupid cheap. They’re cheaper than U.S. banks got in 2009.

Daniel: Part of the reason for that is they have a habit of extending and pretending, so what’s the loan quality? I don’t know. But at the valuations they’re trading at, maybe it’s worth the risk.

Tim: There’s a large buyer in place now in Japan. One of the larger conglomerates, SBI Holdings, is starting to put money into two of these little regional banks. We’re talking just in the last few months, but the CEO’s plan is he’s looking at as many as 70 of these regional banks. And he’s got $1 billion to spend. He’s going to re-capitalize a bunch of these [companies].

Daniel: That’s a very interesting one. I like that one a lot.

Tim: In the U.S., we’re going to go back to the subject of private equity. Money’s flying into private equity because the trailing returns are so good. We’ve got money flying into an asset class where credit quality is deteriorating, and they’re paying up for deals. Do you see any scenario where this ends well?

Daniel: I don’t. Massive amounts of debt and wild investor enthusiasm lead to crazy valuations. That doesn’t tend to work that well. It is something I tend to steer away from. I think you’ve got to understand there are big pools of capital with non-economic incentives that are rushing to private equity. Let me just explain two of them.

One is institutional investors. What the institutional investors get from private equity is marked to made-up accounting that smooths the volatility and reduces career risk.

A private equity fund has reported volatility that is below the volatility of corporate bonds. They’re investing in leveraged microcaps and saying it does well over the corporate bonds.

If you’re an institutional allocator, say Q4 at 18, the public market’s down 15%, private equity is down 1.5, you’re sitting there and saying, “Look at all the alpha generated. I’m running a much less risky portfolio.” When in reality, they’re actually running a much riskier portfolio.

They’re just relying on accounting statistics that suggest otherwise. Huge amounts of institutional money love private equity because of this return smoothing.

The second pool consists of consultants. The consultants are immensely powerful. They intermediate about 90% of institutional money is going through or advised by consultants. Consultants make a significantly higher fee on recommending private investments than they do on public investments.

If you’re trying to grow your consulting business, it behooves you to get larger and larger sales of your clients’ assets into private assets. The gatekeepers are pushing it. Allocators love it. All of this is driving what I would say is non-economic flows and the non-returns-oriented flows. People are incented to do it for reasons that don’t have to do with returns. I think that’s obviously very worrisome. It should indicate low perspective future returns.

Tim: That’s really going to disappoint a whole bunch of pension funds that are hoping private equity and oddly enough private credit are what’s going to bail out their deficits.

Daniel: That is not going to happen. It’s not going to work.