[MUSIC PLAYING] [APPLAUSE] JEFFERY C. HOOKE: It's
obviously a pleasure to be here. I'm going to start
off by taking a poll. How many people
have heard the fairy tale "Jack and the Beanstalk?" OK, most of you. Well, as you recall
from that fairy tale, Jack was asked by his
mother to take the family cow to the market and sell it. Instead, he was waylaid
along the way to the market by someone who
offered to exchange magic beans for the cow. And those magic
things were supposed to translate into great wealth
for Jack and his mother. So in that particular case, as
you recall from the fairy tale, the magic beans
did return wealth. He had to steal gold from
the giant way up above. But it did result in wealth
for Jack and his mom. But when we talk
about private equity, they have the same system. They're promising a magic
elixir, or magic beans for investors-- that they're
going to beat the stock markets dramatically. And as we're going
to learn today, it simply isn't the case. And that's why the
subject of this talk is called the Myth
of Private Equity. So I like to start off a talk by
telling you exactly what we're going to go over. So we've got six topics today. We've got my background. What is private equity? Is it a savior for
institutional investors that want to beat the stock market? We'll talk a little bit
as [? Pernesh ?] indicated about private equity returns
and the associated fees. And then we'll close with,
how do big institutions select a private equity fund? And then I'll take
some questions. So my background is
a little unusual. I've had a number of
different positions. I was an investment banker
in New York for 15 years. I was an institutional
lender both in New York and at the World Bank
in Washington, DC. I've done private equity
in the emerging markets for a very large
private equity fund as well as for the World Bank's
private equity operation. As he pointed out,
I'm an author. I've also been an expert
witness in front of judges regarding financial matters. And as he pointed
out, I'm currently a professor of finance. So I've had quite a number
of different positions. Deal-wise, I've done
deals all over the world. I've done US. I've done deals in Asia,
Latin America, Europe. There probably isn't a
deal that I haven't seen-- M&A, IPOs, large debt
offerings, project finance. I've kind of seen
it all in my career. And that's led me to look
at things in various ways because I've been exposed to so
many different transactions as well as different
cultures-- how people in various countries
and various institutions look at transactions
in corporate finance. So I've had sort of an
intellectual bent, which you don't see with a lot
of Wall Street-type people. And so I kind of analyze things. I don't think it's necessarily
helped my career much, but it's been interesting. And of course, you've
maybe heard the expression, the unreflected life
is not worth living. So I guess I've
lived by that motto. Some books-- as he pointed
out, Wall Street-type books-- but I've done some academic
work lately as a professor. And the professors that I've
worked with, we've done papers on private equity,
state pension funds, and we just finished
a paper that's going to be published by a
journal on private foundations and their investment techniques. I do a lot of pro bono work. If you don't know what pro
bono means, it means free. It's Latin for free. Because I have quite an
investment banking and finance background, I've done work for
citizens groups and taxpayer groups in these four areas-- tobacco lawsuit fees, which
ran into the billions, like, 15 or 20 years ago. Casino legalization
in various states-- Many of the legislators wanted
to give these casinos licenses out for free. I thought it was wrong. I thought it was un-American. So I led a fight to try to
get these states to charge quote, "fair market
value" for these licenses. And we had some success. It probably cost the casino
industry $2 or $3 billion in fees. Public utility mergers,
where the utilities aren't giving enough of
their benefits of the merger to the ratepayers-- and then, as I said,
I've also done, not only academic research,
but some testimony on behalf of state pension
funds and investors and employee unions to see that
those things are run properly. My pro bono work also
extends to the CFA society. I'm a big fan of
the CFA Institute. And so when I do travel-- sometimes on vacation,
sometimes on business-- if I have enough
advanced notice, I'll contact the
local CFA Society. It's a global organization, so
I've been in front of audiences in places, like
Moscow and Thailand. So it's been kind of
interesting there as well. I know some of you are in the
Investment Club here at Google. Investment Club
often means, I like to buy stocks and sell stocks. So I'll talk of
a couple of words about stock picking
based on my experience. Tens of thousands of
people are involved in the picking of stocks. And many are
extremely well-trained at the top business schools
and have a lot of experience. So if you're picking
stocks personally, you remember, you've got a
lot of competition to be right and, actually, to
beat the market. So even with all these
smart people doing it, it's very tough to
beat the market. Most professionals can't do it. And these people are working
24/7 trying to beat the market. They just can't do it. Those that can consistently
beat the market, it's a very small percentage. If you look at fund managers
going up against the S&P 500, less than 0.1% have beaten
it over the last 10 years consistently. So they have the
rare combination of extreme ability and luck. And if you look
at statistically, if you're guessing, buy
or sell for 10 years, if that's a binary
choice, the chances of being right for 10
years are 1 in 1,000. So it's tough, tough
to beat the market. I think it's a good
hobby, so I do it, even though I don't think my
results are that terrific. I think it's a good hobby. It's easy to measure your
performance against the market. It's objective like being a
baseball hitter or something. But if you are someone like
the people in this room, you probably have a
job that's full time. You're not going to be able
to really research stocks effectively against the pros. So I would say reserve part of
your portfolio for fun stock picking, but index most of it. So let's get to the
topic of today's talk, which is private equity
and why it's a myth. I'll describe private
equity for a minute. So the way a private
equity fund works is, you have a number of large
institutional investors-- 10 or 15, sometimes 20-- putting in tens of millions,
sometimes hundreds of millions of dollars into a fund. So it's a big pot of money. And the fund is run by
investment banker-types like myself. And so the fund is buying
companies for the most part. And it's going to have a
portfolio of, say, 5 or 10 companies. And then these
companies are then going to be sold after a
certain holding period. So it's like a mutual
fund, except the number of investments is very small,
and you control each one. So the fund is
actually in control and helps guide the company. So the interesting thing I find
about private equity as opposed to, say, a mutual fund is
that the investors have a much longer time horizon. So if you're going to buy
companies and then sell them, first, you have to find them. So finding a deal, in itself,
is a full-time job, believe me. Then you have to negotiate
and close the transaction. So if you've got a fund
of, say, $1 billion, that's going to take
three or four years to invest that $1 billion. Then, over the next
few years, you're trying as a PE fund
manager to work with the management teams
of these various companies that you own. You're trying to
improve the company. Much like if you buy a piece
of real estate, you may say, well, I'm going to paint it. I'm going to put an addition
on it, and then I'll flip it. So they're trying to
do the same thing. Except, in a
corporate world, where they've got a few
years to try to improve the earnings of the
company, improve the sales and then get the
company ready for sale. Get this company ready
for sale and liquidation. So then they've got three or
four years after the holding period to sell the company. Now, most of them are
sold in M&A deals. There are very few IPOs
in the United States. There's only a few
hundred every year, where there's 15,000
M&A deals every year. So then they sell the companies
at the end of 10 years, and hopefully, the investors
have got a good profit. So if you look at it in the
narrow stock-picking way, these managers are
picking companies almost like you might pick
stocks in a portfolio. So they're very concentrated,
but they're essentially picking stocks, except they're
buying the whole company. So that's the way they do it. Now, this chart doesn't show it,
but there are three categories that dominate private equity. The largest one would
be Leveraged Buyouts, and I'll talk about
that in a minute. Venture capital and growth
equity would be about 20%. But LBOs would be
over 60% of the money. And what's a Leveraged Buyout? Well, a leveraged buyout fund-- it's got a basic
strategy here, which is you buy 5 or 10
low-tech companies. They have to be non-cyclical,
and they have to be profitable. So they can borrow
a lot of money. Banks like loaning to
firms that make money. And so the idea is that the
LBO will have a lot more debt than a similar publicly-traded
company like those in the Russell 2000. And the idea, very basically,
is that the more debt you put on a conservatively
managed low-tech company, the lower the cost of capital. If the market goes
up, the stock market goes up, as does the M&A
market at the same pace, the internal rate of return of
the private equity portfolio will be greater than
a similar portfolio of publicly-traded stocks
because it has more debt. More debt would mean higher rate
of return to the equity holder. Of course, if the stock market
falls, the reverse happens. So you will have
more losses compared to the public market if
you've got a lot of leverage. So the private equity
fund, in theory, should have more volatility. It should go up and down more
than the stock market because of the greater debt. But the returns will be
enhanced either up or down. Now, venture capital
funds-- you know, we're here in Silicon
Valley-- venture capital is a little different. But it's the same principle. You buy 5 or 10 Venture
Capital investments. There, usually the private
equity fund or the VC fund is not controlling the company. They don't own a
majority interest. They're buying companies
that are already in business for the most part. So they're not working out
of a garage or something. And not all the VC
investments are high tech. So here, the companies
are a lot younger than the buyout business. So the VC partners are
providing not only cash, but some guidance and advice. So it's a little different
than the LBO business because I think there's more
involvement with the management team. So the fundamental objective
of the private equity industry is they'd like to
beat the stock market. Because if they're not
beating the stock market, the investors-- big
institutions, like Harvard, or Singapore Sovereign
Wealth Fund-- will say, what do I need you for? I can just buy public stocks. So the idea is to have a higher
rate of return with less risk. That's the sales pitch. So if you look at
that sales pitch, it would put the
private equity business at a higher rate of return
the S&P 500 with lower risk. Now, some of you may
remember, if you ever took a finance course, that that
defies all finance theory back from the '50s. Supposedly, if you're higher
than this market line, the market will come in. Everybody will invest
in this and, therefore, drive the returns down to what's
on the securities market line, it's called. So that's the theory. So it contradicts the theory. A lot of PE
investors are saying, not only do I want to have
the S&P return from my Private Equity fund, I want to beat it. And that's because you
can't sell these funds. You can't sell your part
of a private equity fund like you can sell stocks. And you're also not
getting instant feedback on what the price of your
private equity portfolio is, because there's some
uncertainty about what a private company is worth. So there are thousands
of funds out there. As I said, I used
to work for one. And the idea from the
fund manager's perspective is, I want to start fund one-- getting the fees
from the investors and hopefully getting profits-- and then, while this fund
is four or five years old, I'll start the next one. I don't need a lot of extra
management to start a new fund. So I'll start this fund
next, get these from that while I'm selling part of one. And then, as fund two
starts getting invested, I'll go to fund three. So I'm compounding the profits,
and I've got economies of scale with the management. Now, as I said, it'd be
nice if investors could beat the market with these funds. And earlier, they were. Say, before 2005,
as you can see, the funds that were
started before that were consistently
beating the S&P 500. But people then started
plunging into these funds. Because these funds
got much bigger, there was more
competition for deals. And so, as you
might expect, when there's more competition
for transactions, the cost of the M&A goes up. And the returns, as
a result, declines. So over the last 12
years or so, the returns have not been very good
relative to the S&P 500. And if you look,
this is buyout funds. If you look at venture
capital, there's a similar return
pattern where people were piling into these funds,
and so the returns have not been so terrific. So if you look at
fees as one element of the whole private equity
equation, they're pretty high. So the fees on an
indexed mutual fund that you might buy from
Vanguard or Fidelity might be five basis
points a year. They're peanuts, almost nothing. And in fact, there's
been some news that Fidelity is starting
to offer funds for nothing. So you would invest in
it and not pay anything. Private equity,
on the other hand, is about 300 basis
points a year. So the fees are
60 times as great. So the manager of the
private equity fund has got to beat the S&P by 3%
every year just to compensate the investors for the fee. So that's pretty tough. And so if you look at it
like this kind of graph, getting into this part of
performance is so hard. Just a small
percentage of people can do that with
the public markets. And as a result, with
the high fee drag, you're not investing the
investor's money 100%. Perhaps, the private
equity fund's only investing 80%
of investor's money. So there's a lot of
hurdles that the PE fund has got to conquer to try
to beat the stock market. And I looked at one fund. A lot of states, a
lot of universities, and a lot of big
institutions don't know what their carry fees are. They don't ask. So they're not billed
for a carry fee. The fees are deducted before
the investors see their returns. The only fee that is disclosed
in an accounting way as 1.8%. So unless the state or
the university asks, they don't get the carry fee. New Jersey is one of the few
states that actually asks. So I just put that
up here on the slide. It shows you the fees
are about 3% last year. Now, the interesting thing
about private equity funds is the performance-- for the positive,
performance is really dominated by the
top quartile, which means the top 25% of
funds do very well. The second quartile is
around the stock market, and the third and
fourth are below. So you've got half the
people that don't have a very good batting average. And if you look at
venture capital, the chart would be
very, kind of, similar. The interesting thing about
those performance numbers is that a lot of the
performance numbers are based on transactions
that haven't been sold yet. In other words, the PE firm
has bought the company-- hasn't sold it yet. So how are they measuring
their performance? Well, they have the
ability to mark to market their own investments. Nobody's really double-checking. Like the auditors,
the investors, the limited partners
do not check. It's sort of an honor system
that always surprised me. Maybe I'm a little
hard-bitten and cynical. But it surprised me that
trillions of dollars going in, and nobody's really checking it. So I liken the whole
process to a third grader grading their own
homework, which is a little strange for
this kind of business. So here's the evidence. So if you look at buyout funds,
these are, like, 10 years ago. And this is statistics--
are reasonably recent. You can see, even,
like, 2010, 2011, most of the returns that
they're vouching for haven't happened yet
in terms of cash. Now, these deals
haven't been sold. So you've got funds that are
seven, eight, nine years old that haven't sold half
the stuff they own yet. So I question a little bit
whether they're worth as much as the managers say they are. So if you want to get a
little more into the weeds, are they really worth
as much as they said? I did a study with
one of my colleagues. And we looked at what was the
market experience in the crash? You would expect a company
with more leverage, like the portfolio companies
of a leveraged buyout fund to decline more than the
stock market for the reasons I mentioned earlier. But if you look at
the way they reported it, the leveraged buyout
industry said, guess what? Our results were better
than the stock market, despite our higher leverage. So that, again, would
strike me as being totally the opposite of what
finance theory would tell you. So we call that-- "return smoothing"
is the expression. So you have the flexibility
to put your own markings on your portfolio. You're obviously going to
do it a little slightly in your favor, if you're
a rational person, to make yourself look better. Of course, as I
said, the sales pitch is, not only do we have higher
returns in the stock market, but we're also less volatile. Anyway, the sales pitch
has made believers out of a lot of big institutions. And so I looked, again
with one of my colleagues-- we looked at pension fund
returns to the big states, like California,
New York, Maryland. We looked at their
pension funds. And they've made a
much larger dedication to alternative assets
like private equity funds, hedge funds. But that stampede into private
equity and other alternatives has not really provided
a higher level of return. So if you just compare your
average state pension fund or endowment with a
60/40 index that you can buy from
Vanguard or Fidelity, there's a big difference
if 60/40 outperforms that by a significant margin. People that aren't really
acquainted with math say, well, it's only 1%. What's the big deal? But if you're running
a $50 billion pension, and it's 1% every year,
that's $500 million a year. Sooner or later, you're
talking some serious cash. So how do these
institutions, how do they pick the
private equity funds? They're trying to do their best. They're trying to find ones
that are in the top quartile. How do they do it? So there's two ways they do it. One is they look at a fund
that was in the top quartile previously. So that fund is coming out with,
let's say, fund number two. So the investor would
say, OK, they did well in fund number one. I presume they'll repeat the
performance in fund number two or fund number
three, in this case. So what is the
statistical probability of the third or the second
fund beating the prior fund? It's about 30%. So it's almost random. So that, in Wall Street terms,
that's called mean reversion. You may be doing
well for a while, but then, gradually,
as time goes on, you revert to the average. You're the same
as everybody else. So with LBOs, it's about 30%. So it's almost random. With VC, there seems to
be more staying power. VC firms are more adept at
repeating their performance. Now that's one option. So you try to go to
your top-quartile funds, and hope they repeat
the performance. Unfortunately,
most of them don't. So what about option number B? That would be where you say,
I'm just going to play it safe. I'm going to pick a
big brand-name fund. I'll go with Goldman, or Carlyle
Group, or Kohlberg Kravis. They've got six or seven funds. There's a history. They're big names. I'll just invest in them. The problem with
that is that if you look at the big-fund
families, like Carlyle, or Apollo, or KKR, they don't
outperform the no-name fund. So strategy A or B doesn't
seem to be a good option. B, obviously gives the
people at the pension fund or the endowment
some air cover. They can always say,
well, it wasn't my fault that the fund screwed up. I went with Goldman Sachs. They're supposed to
know what they're doing. So there's the old
saying, you can't get fired by going with IBM. It would be the same thing in
the private equity business. Portfolio patterns-- how does
it look with these funds? If you've got 10 companies in a
fund, like a leveraged buyout, you've got about three
that will go bankrupt because of the high debt. Sometimes it doesn't work out
when you borrow a lot of money. Four will be OK in
terms of returns. Three will be, as
the saying goes, home runs where it might be
a 20% or 30% rate of return. The VCs are a little different. There, it's more of a crapshoot. You're dealing with
younger companies. A lot of times
they're technology, so they're undeveloped. The customer base in
technology are not known. So you've got a lot
more bankruptcies. When they do hit a premium
return, it could be very high, just big returns on, say,
a boring, low-tech company in the buyout business. Couple of case studies
for those of you that are interested
in venture capital. I'm sure you've all
heard of this one-- Theranos. I guess, once you get
on "Forbes" magazine, that's, like, the end of it. I always used to think,
when some CEO writes a book, the stock is going to tank. Because I've seen
so many instances where there's a book come
out, and then the stock of the company tanks. This story is kind
of well-known. She invented the--
what people thought was an exclusive technology to
do blood tests just pricking your finger instead of
getting a needle in your arm. And people were
buying the story, put in hundreds of
millions of dollars from very knowledgeable
Silicon Valley investors. She got a lot of publicity. Most of it was pretty good. The value of the company
on a private basis went all the way
up to $9 billion until the roof caved in when
the "Journal" started picking up rumors that the technology
really wasn't what she and others said it was. And of course, the
company, I guess, just announced it was
liquidating a couple of weeks ago. So the investors and the
equity were totally wiped out. What about a good one? Why talk about bad? Let's talk about a good one. There are many good ones. Roku is a real success story. So it's about 10 years old. They invented the first
streaming box for Netflix. And then they developed
some other products and went the normal
process that you'd like to see for a high-tech
company of raising VC and gradually
getting a higher value and then going public
at a big number. And everybody got a
terrific rate of return. Now Roku is still losing money
despite all this success. So we're just going to have
to wait and see in a few years if it turns out to be a real
solid business entity that can sustain its momentum. So you might say, why
do people still invest? Why do big institutions
invest in private equity? Haven't they seen
these statistics? Well, I'm a little bit of
a student of human nature. And I've come up with a
few theories about it, having talked to many people. So I think one
category of investor may be a true optimist. People always like to
think they can do better than the stock market. They're saying, I think I've got
a plan that we can do better, and I think private
equity is the way to go. So these would be
the true believers. And I was doing some work on
behalf of New Jersey employee unions. And I was looking at the
private equity portfolio. And I remember hearing the head
of the investment committee talk. And he's saying, Mr. Hooke
doesn't know anything. We only invest in the top
quartile private equity funds. They invested in 100 different
funds, and I looked at them. And I looked at
their performance on a private equity database. And they weren't top quartile. They weren't bottom,
but they weren't top. If you took all
100 together, they were exactly in the middle. They were doing, say,
between the second and the third quartile, which
is what you'd expect if you selected the funds at random. But you have these people
that simply believe that. Now, the other group would
be institutional investors that listen to their
consultants a lot. So every big pension
fund-- most endowments will have a consultant that
would tell them, here's the portfolio
allocation you have. You should allocate some
to stocks, some to bonds, and some to alternatives. So they're always
pushing alternatives, these consultants. And so if you listen
to them, you're going to be in
alternatives yourself. Now a cynic might
say, why are they pushing alternatives if they
have seen these statistics? Well, if you are
consultant, you're getting paid millions
of dollars a year, why would they
continue paying you if you just walked into
the office and said, I think you should index
the whole portfolio? Well, then they say, well,
what do we need you for? C is the one I think is
probably the most applicable. And it's unfortunate. But if you're working
at a big endowment, or if you're working at
a big state pension fund, you're in the investment office. You have a job of
picking managers usually. So you're not investing
the money yourself. But you're picking managers
in stocks, or bonds, or hedge funds,
or private equity. So it's unlikely
that you are going to look at all the numbers
and say, well, our strategy is wrong. We screwed it up to last
10 years because we're not beating a 60/40. Those people's jobs
are dependent on having a lot of different investments
to manage and supervise. So if they were to walk into
the board of directors office and say, we can't produce any
premium return over an index so I, therefore, hand
in my resignation. Not many people are
going to do that. In finance, that's
called an agency problem where the investors are using
the managers as agents, hoping to get a good return. And the last one is really what
I call the Stockholm syndrome. The Stockholm syndrome
is based on people, like, 20 or 30 years
ago that were kidnapped by a gang in Stockholm, Sweden. And so over time, as
they were kept captive, they started sympathizing
with their kidnappers, believing what the
kidnappers told them. And it was kind of
a very interesting psychological
experiment or situation. So if you talk to people in
the business, many of them go to conferences,
and they're all talking about how great private
equity is or hedge fund. And so if you hang
around people, and they talk about this
stuff, you start to believe it. That might be the fourth theory. But again, as I said,
I think probably C might be the overriding
theory of why we still see a lot of private equity. I like to tell my classes
at the university, private equity M&A is a
business for optimists. So you have to
think you're going to do better than the average. And human nature tends to be,
in many cases, optimistic. And that's the investment
business in a nutshell. If you think you can
get higher returns, you're going to be an optimist
relative to many others. So there's a little
bit of a circular facet to this where you've got
the claims of the PE funds. And they basically
can, as I said, mark to market their
own businesses. Many PE fees are secret,
so people don't know what the states are paying. Accounting doesn't require
that the fees be disclosed. So it's a
self-perpetuating circle, and it's been very effective. That's why, if you believe in
the efficient market theory, you'd say, well, wait a second. Time out. There shouldn't be a private
equity industry as big as it is. But the market's
not quite efficient, because the information
simply isn't out there for many of the investors. So on that note, I will stop
and take a few questions. Anybody have a question
they'd like to ask? AUDIENCE: Thanks, Jeff. Appreciate the talk. I was wondering if you
had the same sort of view towards private equity
funds that, say, that they specialize
in a particular asset class like real estate or
infrastructure funds versus, I guess-- well, yeah, do you have any
thoughts about those types of funds, how they
compare to funds that are purchasing businesses, like
LBOs versus, we invest in roads or whatever? JEFFERY C. HOOKE: Sure. Well, infrastructure
funds are kind of too new to be analyzed in
that way where you can look at a long-term track record. The other problem with
infrastructure funds is there tends to be no
public equivalent that's easily definable in the same
way as a private Infrastructure fund. So that would be a tough one. Real estate, on the other
hand, has a long track record. So private real estate funds
would do roughly the same as publicly-traded REITs,
Real Estate Investment Trusts that are publicly-traded
vehicles that buy real estate. I haven't done a whole
lot of study on this. But if you look at
private real estate funds, they also tend to
be less volatile than publicly-traded
REITs, which has raised some questions about
their mark to market ability. AUDIENCE: I think I'm
pretty [INAUDIBLE].. JEFFERY C. HOOKE:
[? Pernesh, ?] you got one here? Go ahead. AUDIENCE: So I noticed that
there were folks like Ray [INAUDIBLE] and whatnot-- the fact that they
kind of double-dip-- they're in the VC world,
and they're also in PE-- what is that called
when they do both, or they kind of play
around in both worlds? JEFFERY C. HOOKE: Well,
it's clear these folks are running a business, right? They're running a business
to obviously benefit their investors. But also, they've got
to benefit themselves as the owners of the
business or the PE fund. So the trend for
the larger ones is, we've done about
all we can in VC. We can't grow much bigger in
that market, because there just aren't enough good investments. So it's not unusual that they
say, well, some of the skills are very similar
to private equity. So we'll take what we've
learned in venture capital and transfer it to growth
equity or, maybe not buyouts, but growth equity. And I agree with them. I think there are a lot of
similarities-- deal closing, evaluation of
companies, evaluation of management and markets. So it's a natural progression. And you've seen some of
the bigger buyout firms, not only go into
growth capital-- not so much venture
capital-- but you see them going into hedge funds. You see them going
into lending, where they say, well, we've
done a lot of buyout deals as an equity investor. We can also do lending. So it's just diversifying
your business makes the patterns of earnings
more stable and predictable. AUDIENCE: I was wondering if you
know any differences in, say, attitude for
investing in cultures, for example, in other
countries, like Asia, versus the United States? JEFFERY C. HOOKE: I got
into Asia quite a bit. I think you've
got to distinguish between retail investors
and institutions. If you go to retail
in Asia, I think they're much more
interested in speculation. Here, I think investors,
even the retail tend to be more
analytically inclined. And they might study the
PE ratio of the company, and how does it
compare to others, and what's the growth record,
and all that sort of thing. But I think the Asian retail
investor will be saying, oh, I heard it's a hot stock,
and they go and buy it-- not do much analysis. Not that they don't do that
here in the States and Europe, but I think they'd be a little
more on the speculative side. Institutionally, I haven't
noticed much difference between, say, a big Chinese
sovereign wealth fund and, say, a big university. I think they tend to
travel in the same circles, and they sort of do the
similar investing techniques. See you later, Kurt. AUDIENCE: Hi, Jeff. Thanks for the talk. Just riffing off the
previous question, if you said the retail
investors in certain countries or locations tend to be more
whimsical or so, have you seen, in your studies,
a correlation, we would say, of PE
being successful in some areas versus not-- some emerging markets versus-- there are these
compounding factors that basically make them any
bit more successful or not? JEFFERY C. HOOKE:
Well, there are PE in lots of
emerging markets now. But it's a relatively
new phenomenon. Private equity in, say, India,
or Malaysia, or South Africa-- I don't think there's enough
data points really to measure it, whether they have PE
funds in emerging markets have beaten the ones-- I shouldn't say-- where
they've beaten the stock markets in those countries. I just don't think there's
enough information there. AUDIENCE: Thank you
for the lecture. I couldn't help but note the-- you presented a
great slide, which was the history of performance
relative to the S&P or was it a 60/40? I wasn't quite clear which. And it seemed
fairly clear that it was working relative to
the S&P for a good while and then stopped. Do you have any theories
about why that is? JEFFERY C. HOOKE:
Yeah, of course, I do. Sure. I wouldn't be here if I didn't. I've talked to a bunch of
people in the business about it. I think, when there
was a lot of success, as this chart points
out, investors just started buying into these funds
based on their historical track record. And so as I sort of
suggested, as people pile into these funds, the
prices for the targets-- because there's
only so many targets out there that fit the
requirements to be a buyout candidate, for example-- so the price of the
targets, therefore, went up. So as the price of
the targets goes up, the corresponding return to the
LBO investor drops a little. It doesn't go to zero,
but it drops a little. And so the difference, you can
see, is illustrated by here. Once people started looking at
this track record, they got-- '05, '06, '07 were some of the
biggest years for new funds. So there's a lot of
competition for deals. And I noticed that because I
am part time at an investment bank. And I see the competition
for transactions where, for an LBO candidate,
we might get six, seven offers. So who's the winner? The one that offers
the higher price. Of course, the winner,
then, could be the loser as they're paying
too high a price. So you've got supply-demand
because there's so much money trying to
find the same transaction. The other aspect
would be the fees. The fees are just high. So if you've got a
pretty high fee level, that's just going to be
a drag on the return. Any other questions? I got one over here. AUDIENCE: Similar to that
point, in the last few years, there's been a lot of
discussion about the value-- just [INAUDIBLE] index
funds and go that route. And so a lot of money is
flooding that way now. And do you anticipate
that there's any type of similar
kind of effect that was actaully had when
you saw the returns on PE was great. A lot of money came that
way and, eventually, then the returns aren't there? Is there any potential the same
thing's happening on the index side now that people
are just investing their equity into index funds? JEFFERY C. HOOKE: I
think, at some point, if there's too much money
going into index funds, then there's going to be
more opportunities for stock pickers-- people that study and then
pick individual stocks. Because so many passive
funds will misprice. They're just buying stuff
based on market cap. But if you look at the retail
market for mutual funds, it's about 30% indexed. And institutionally,
big pools of money like pension funds, or
endowments, or universities, I think the indexing is only
around 15, so it's small. So when I've thought
about it and talked with people, whose
opinions I respect, I think the indexing part
can probably go to 75% or 80% before indexing
returns will then be beat by those people
that aren't indexing. So there's a long way
to go, long way to go. The other thing is that-- perhaps I should
correct myself-- there are a lot
of people managing money that do what's
called closet indexing. So they're running a big large
cap fund for some money manager or some state pension fund. So they're trying to conform
their results to the large cap index. So they are, in effect-- even though they claim they're
picking stocks and doing all kinds of analysis--
they're trying to stay close to what the
stocks are in the index so that they won't
outperform or underperform it by any meaningful amount. So that's a very conservative
strategy, you might say. But I think, if you
include closet indexing-- my percentages, you
maybe double them for what's indexed right now. Over here. AUDIENCE: Thank you
for the talk, Jeff. I have a question. So do you think the competition
from the private equity actually leaked or
affect the public market? For example, for
the recent year, it seems the price of the IPO
or the valuation of the IPO is pretty high, and there's
not much juice out of the IPO. So is that part of it? JEFFERY C. HOOKE:
So the question is, is the private
equity market competing with the public market
for new listings? I'd say, absolutely. You have a lot of
companies that you'd think would be a good IPO candidates. And they're saying there's
so much private equity money out there, why
should I do an IPO? Because it's a pain in the
neck to be a public company. You've got everything laid
out there for everybody to read about. You've got so many regulatory
matters you have to address. Everything that you talk about
on TV or in press releases can be microscoped by a lawyer. So for many companies, I
think it's a better idea to go private equity. So there's so much
private equity, I think they're really
retarding the number of IPOs. And I don't see that
process slowing down. I personally, would
like to see more IPOs so public investors
have a shot at getting into a lot of growth companies. But right now, there's just
too much private equity money available. And I'm sure you see it here
in Silicon Valley a lot. You see a good little
company and say, well, gee, that's a good
IPO candidate. But it's just not happening. The other factor, which
you often hear mentioned, is that the investment
banking community has shrunk considerably. So now you probably
have 5 or 10 firms that really dominate the business. And they would
dominate IPOs as well. So they tend to want
to see bigger deals. They're big companies. It's economical for
them to do large IPOs. So with the demise
of many smaller banks who got acquired
or just closed, you don't see as many smaller deals. There just aren't enough
people to sell them. So you've got those
two factors, I think, working against the public
market-- having more listings, at least for now. AUDIENCE: Thank you. AUDIENCE: I have a general
question about valuation, since you've written
such a great book. During the Graham times, there
was a lot of focus on price to book. And then the world moved
on as the economy changed and the nature of
businesses changed to looking at P/E ratios and
price to free cash flows. Do you think there's yet
another paradigm shift, or this is more where
a good idea is taken to an extreme, which of
the two it is where you have a very intangible economy. Customers acquired
now, whose values are realized over
the long time, and PE doesn't reflect that economics? JEFFERY C. HOOKE:
Well, you remember when Graham and Dodd
wrote that book, we were just getting over
a huge stock market crash. And so the book was ultra
conservative saying-- it focused heavily
on the balance sheet. That's your backup plan. If you had a strong
balance sheet, it's unlikely that the
company could go bankrupt. So that was sort of
their starting point. Look at the balance
sheet, then let's look at the income statement. So now, it's reversed. People are looking much more
at the income statement. And I guess that's been
pretty much the fashion for the last 30 years. And that's sort of
what my book was-- sort of an update of the Graham
and Dodd authoritative book. And I don't think the
paradigm has really changed. I think people today
are still focusing on, as you kind of
pointed out, cash flow, EBITDA, not looking
at the balance sheet much unless it's, say,
a financial institution, like a bank or an
insurance company. What I think has been
noticeable the last few years-- and this is sort of a
repeat of, say, '99, '98, 2000-- is people are
more willing to take a flyer on companies
that have a good sales progression without earnings. So they've got good sales. Earnings are going
to come later. And I think, now is sort of a
repeat of, say, 20 years ago. And I think people have
learned their lesson. They're probably being a
little more analytical about it than they were 20 years
ago-- the last internet boom. But I'm still a little
cautious about it. I'm still a little
reluctant to advocate buying the stock of companies
that have huge losses, even though they are
gathering customers that could make a return in
the future for the business. Yeah? AUDIENCE: I guess maybe
what I was trying [? to-- ?] on a more unit economic basis
in the last dot-com bubble. Probably the companies
were not profitable, even on a unit economics
versus today. One could argue that,
sure, they're losing money, but that's because the fixed
costs right now is very high. But on unit economics,
they're still very profitable. And if they got the scale,
then those fixed costs may be covered. Obviously, it's risky to
know whether they [? got ?] to the scale or not. JEFFERY C. HOOKE: No. You're absolutely right. Once you've got the
fixed costs in place for a lot of these
companies like Uber, or Twitter, or
somebody like that-- once you've got the
fixed costs in place, as the customer count goes
up and the revenues go up, you're going to get a lot
of pure profit dropping to the bottom line. But I think, as you and
I talked about yesterday, predicting which ones
can actually pull that off is a little tough. People have tried
it in the past. And most of them that picked
10 or 15 companies that are similar to ones you describe-- it's going to be
like venture capital. Two or three will be
absolutely fantastic returns. Four or five will disappear. And then three or
four will be OK. I'm sorry that's the
way the statistics work. It frustrates people. They're saying, well, I
think I can pick winners. I've got all this training. Or I know the internet business. But it's just very hard
to consistently do it. AUDIENCE: I had a question. In today's low
interest rates, Jeff, how do you think about what
your discount rate should be and margin of safety should
be in valuing equity? JEFFERY C. HOOKE: So a lot of
predictions on the future cash flow then have to be
brought back to the present if you're doing an
analysis of the company. So here, we've
had seven or eight years of very low interest
rates by historical standards. 2% or 3% for government bond is
very low compared to history. So what I do and what other
some other more conservative investors do is say,
well, now, we're in a period of
unusually low rates. So if I'm projecting cash flow
15 years out or 10 years out, to use 2% or 3% as my
base is just unrealistic. So I think a more
rational approach is, what's a normal US Treasury
Bond rate for the last 30 or 40 years? Probably around 5% or 6%. So I use that as the base rate
for some kind of projection, and then I add the risk on top. So if you've got your base
rate of 5, you add 6 or 7 for investing in the stock
market as the equity risk that you're facing. And then you've got to
add another one or two points, depending on
what industry you're in or whatever unique
attributes the company has. So for a garden variety
equity investment I think someone has
to use a discount rate of, say, 11% or 12%
to be fair and objective. AUDIENCE: [INAUDIBLE] JEFFERY C. HOOKE: Thank you,
[? Pernesh, ?] appreciate it. Thank you very much. [APPLAUSE]
