Why you should care
A database-wielding 20-something is challenging the private equity model — and its sky-high fees — with a novel theory and new investment fund.
He’d run the numbers, but they didn’t make sense.
It was the summer of 2011 at the Boston headquarters of Bain Capital, the white-shoe private equity firm founded by Mitt Romney. For Dan Rasmussen, a 24-year-old Vineyard Vines-clad prepster with an unruly mop of Dane-’fro hair, months of work had led up to this moment: a team of analysts and executives quietly amassing a trove of previously secret data on every deal ever done by the 25 largest private equity funds.
As Rasmussen ran regressions on the new database, he realized that something was rotten in the state of private equity.
It wasn’t just the financial crisis that no one in private equity had seen coming. No one ever seemed to see much of anything coming.
Industry managers justify their sky-high fees by citing their due-diligence process and the precise predictive abilities it gives them. But Rasmussen saw something very different in the numbers. “The predictions in these investment cases were way off,” says Rasmussen, a Puckish, know-it-all glee peeking through his somber banker’s tone. “You really couldn’t find any correlation between what the due-diligence process predicted a company’s growth would be and what actually happened.”
What Rasmussen learned that summer led him to create a low-fee hedge fund based on a principle so obvious that it’s nearly been forgotten in the sophisticated world of private equity: buy low.
Once known as the “leveraged buyout” industry, PE rebranded itself after the junk-bond-fueled excesses of the late 1980s. It’s grown by leaps and bounds since then, outperforming nearly every other investment sector and amassing more than $3 trillion in assets.
The company line on what fuels that success is PE’s labor-intensive due-diligence process, a data-driven version of the crystal ball. But that ball had fogged up during the run-up to the financial crisis. To understand why, Bain turned its due diligence on itself and its private equity brethren. As the junior member of Bain’s five-person meta-diligence team, Rasmussen was tasked with creating and analyzing the enormous database of deals.
If he wasn’t ticking someone off, he felt he wasn’t doing his job well.
— Cullen Macbeth, co-editor with Rasmussen on their prep school paper
A voracious researcher who loves overturning conventional wisdom, Rasmussen had unearthed an almost-forgotten Louisiana slave revolt for his college thesis and then pulled all-nighters in his first year at Bain turning it into a New York Times best-seller called American Uprising. Free now to devote his nights to the enormous database of PE deals, he saw that it wasn’t just the financial crisis that no one in private equity had seen coming. No one ever seemed to see much of anything coming. From individual companies’ growth prospects to the broader economy, private equity’s vaunted prognosticators performed worse than if they’d just flipped a coin.
Rasmussen began to think that the entire due-diligence process — with its endless charts and fusillades of industry jargon — was serving only to obscure a very simple investing maxim: pay less, make more.
When private equity firms bought companies for less than seven times the company’s cash flow (EBITDA, in industry parlance), they made money, lots of it. When they paid more than 10 times cash flow — typically for sexy tech companies that due-diligence teams said had “high-growth” potential — profits were rare. And Rasmussen wasn’t shy about announcing his findings around the office.
“Aggressive,” is how Cullen Macbeth, Rasmussen’s co-editor at their tony D.C. prep school’s newspaper, describes him. “If he wasn’t ticking someone off, he felt he wasn’t doing his job well.”
Superiors couldn’t gainsay the dataset, but Rasmussen got plenty of admonitions reminiscent of The Big Lebowski: “You’re not wrong, you’re just an asshole.” Rasmussen might have had a brilliant career ahead of him at Bain, but a Puritanical streak made him question his place in what was starting to feel like a smoke-and-mirrors industry.
That’s when his friend and Bain colleague Jeff Brownlow suggested they strike out on their own, creating a low-fee alternative to private equity investing. Like private equity, they’d focus on public companies with a lot of debt. But they’d only “buy low,” in companies with small valuations.
At the start of 2013 they began investing their own money and that of some friends and family, and in the fall they left Bain to start at Stanford’s Graduate School of Business. Once there, they approached professor Arthur Korteweg, an expert on what drives investment returns.
Rasmussen and Brownlow returned a staggering 86 percent in 2013.
“If private equity firms are making money, where is it from? It’s a question that’s still very much out there, and the jury is still out,” says Korteweg, now at the University of Southern California. “I wasn’t fully convinced when I first saw [their strategy], but of course, that should be the case with any disruptive idea that’s trying to overturn something … if they can establish a solid track record going forward, that has some very interesting implications.”
Just as Korteweg was saying they might be on to something, the markets were shouting it from the rooftops. Rasmussen and Brownlow returned a staggering 86 percent in 2013 (77 percent if you accounted for fees, which they weren’t charging yet). Those results tripled the S&P 500’s returns and almost quadrupled the success of top private equity funds like KKR.
It was time to take their theory public.
On the strength of their very brief track record, Brownlow and Rasmussen raised $11 million to open Verdad Fund Advisers in early 2014. Through two quarters of this more tumultuous year, the fund is down slightly, but less so than benchmark indexes like the Russell 2000. For the last year and a half the fund has far outpaced other private equity firms, but the results are still “too early to read,” Rasmussen cautions.
The real measure of Verdad’s viability will come during serious economic downturns, because investing in indebted companies is a high-risk, high-reward proposition: very good during good times but potentially devastating during bad.
“We felt like we had learned a truth about investing and that we had to show that truth to people.”
Even 2014’s middling returns have been tough on Verdad. A couple of truly ugly quarters before the fund has built up much capital or street cred, and the experiment could sink.
Still, it’s part of a trend of financial products that automate elements of investing and charge drastically lower fees. Like Verdad, many of these companies — automated investment service Wealthfront, the portfolio management tool Addepar — did not start within the hidebound confines of Wall Street, but in Silicon Valley.
“We felt like we had learned a truth about investing and that we had to show that truth to people,” says Rasmussen. “It’s part of the reason we brought this idea to Stanford and the Valley, because people think that way about disrupting models like Wall Street.”
They won’t be making professional investors obsolete anytime soon. But finance, where the companies are incredibly rich and the customers increasingly dissatisfied, is all but asking to be upended.
Much of the financial world, says Rasmussen, “has been mystified, as though there is some kind of magic that people perform. What we’re saying is, there is no magic … and no need to pay those high fees.”