SIP013: Private Equity Investing in Public Markets with Dan Rasmussen and Nick Schmitz - Sure Dividend Sure Dividend

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SIP013: Private Equity Investing in Public Markets with Dan Rasmussen and Nick Schmitz

Today’s conversation is with Dan Rasmussen and Nick Schmitz from Verdad Advisers.

Verdad is an investment firm that seeks to capture private equity-like returns in the public markets by quantitatively capturing the most important drivers of private equity returns. Surprisingly, these aren’t the operational improvements that many private equity firms claim, but more fundamental factors like size, value, leverage, and the willingness to pay down debt.

This conversation also includes a detailed discussion of Verdad’s favorite international market, and why capital allocation differences there make their strategy even more powerful. The first voice you’ll hear is Dan, followed by Nick. Please enjoy this conversation with Dan and Nick from Verdad Advisers.

You can sign up for Verdad’s email list – where they publish truly excellent research – here.

Full Transcript Below

Dan: perfect for having us on the podcast Nicholas so I started for Verdad really the strategy in a very simple origin which is after college I went to work for Bain Capital private equity and private equity when I started 09 the performance track record of the private equity as an asset class from 1980 to 2010 was just unbelievable 6% net of fees per year out performance of the public equity market.

And at the same time I was reading Jack Bogle and What Works on Wall Street, Random Walk down Wall Street and all these books and I was like well all the evidence seems to show that active management doesn’t work and yet I’m working in an industry private equity that we’re active management has not only worked. But worked dramatically and for the average manager and I was at Bain Capital which was one of the top managers and so their own internal record was even better.

It really led me to think well what is driving the returns of equity and I think that instinct from reading Bogle and all these other books was that likely it wasn’t the skill of the managers right of what it didn’t it wasn’t driven necessarily by us being that much smarter than the mutual fund guys that Fidelity or Putnam or anything there’s a special sauce.

But rather there had to be something structural or systemic about private equity and as we started to dig in in 2011 I had this opportunity to work on this projects or dig into being capitalist returns and our competitors returns and try to understand what worked and didn’t work as part of a strategic review of Bain was doing.

And what we found which was really fascinating was that first of all private equity is very different quantitatively than public equity. Really on three dimensions the first is size so the average private equity deal is about 200 million of market cap versus say 30 billion for the S&P; 500 constituents. So really private equity is a micro-cap or small cap strategy.

Second every private equity deal is levered that generally about 65 percent net debt to enterprise value versus public equities which are generally unlevered or levered maybe ten percent net debt to enterprise value on average.

And then third that for there’s a very strong correlation between purchase price and returns such that the cheapest 25 percent of private equity deals explained over 60 percent of the industry’s profits and there is almost a direct almost like a 90 percent correlation between the discount between private equity average purchase price paid by private equity. The average multiple paid by public equity and how much the private equity of into gri performed. and so essentially if you thought will from that perspective it wasn’t that the private equity managers were geniuses is that they had been systematically buying 65% levered micro caps at five or six times EBITDA. Which was half the market valuation for 30 years and that had worked astronomically well.

But what has happened and by 2011 this was very clear because it really started in Oh 405 but by 2011 was totally true is that looking at the store core terms of private equity asset allocators had started to say well gee this asset class is amazing returns and they went in they talked to the private equity guys say so how are you making these returns the private actors said.

And we transform the companies that we own which is at an accurate view of how they spend their day-to-day job and they never mentioned the fact that historically they’ve been buying 65% levered micro caps for 5 you know 50% discount to the public equity valuations.

And because there is no that sort of quantitative anchor wasn’t in the alligator’s minds they started pouring money into the asset class which drove the prices up such that bio set by 07 prices were pretty close to the public markets and then since about 2010 on they’ve been equal to and now almost higher than public equity valuations. and my view is that private equity is extremely price sensitive as we’ve discussed and then if you’re buying stuff at ten times EBITDA rather than five times even your returns are going to be a lot lower and in facts is my view from looking at the data was that at greater than ten times even say you wouldn’t beat the public equity market so that essentially because you’d be putting too much leverage 65% leverage at ten times he was six and a half turns he would which is bankruptcy risk territory it’s way too high.

And so my view 2010 was that as long as multiples were about ten times u-dub private equity wouldn’t underperform the public equity market because the quantitative drivers were what was driving it not the genius of the manager. And sure enough from 2010 on private equity has underperformed the public equity markets by about a percent or two a year and so the magic of private equity turned out not to have been diligence scale or operational transformation but rather this quantitative profile which was so excellent.

When I sort of realized this at Bain Capital I said well gee I could do this much more effectively and systematically and focus all of my intellectual energy on the stock selective process and the sort of intellectual aspects of building an investment rather than deal sourcing and process its and so I left them to go to Stanford GSB to sort of test this quantitatively in essence to work with Charles Lee he was one of the top finance professor Stanford and Bryan Django know who’s not on the call but he was at Chicago at the time he’s our director of quantitative research and he was working for our official University of Chicago. And we said what we want to do is basically look at the universe of US companies that have traded at less than seven times even greater than 50% lever and we’re smaller micro caps and see if the returns on that class of equities look similar to the gross of fee returns of private equity.

What we found is that it did and that all those sort of insights that we had from our initial hypothesis about the importance of valuation and it’s interaction with leverage were all true and so in essence what you could do is build portfolios of these small levered companies that looked like 1980s or 1990s LBOs and would have returns that looks like rather than this sort of high-priced over levered mediocrity that is the private equity industry to that.

So that was sort of the intellectual genesis of Verdad and what we then started to do is I’ve worked at Bridgewater before and my view is that you don’t want to just prove that something works you want to replicate it across multiple market cycles across time.

We’d seem that it worked and private equity was seeing that it worked in public equities in the U.S. back to 1965 and so we said well what’s the next big market and that we could test in Japan as the second biggest equity market in the world and so we decided to test it in Japan back to 1991 and we ran that study and found fantastic results totally replicated what we’ve done. but there was this totally bizarre anomaly which was that in Japan the volatility of the strategy was dramatically lower and so at that point I was like this does not make any sense and I was like how can I figure out how this could possibly be true and I thought of Nick who’s my best friend from business school and Nick fluent Japanese that we met literally on day one at Stanford.

Nick was working at Goldman covering Japanese clients so I called Nick up and I said Nick help me figure this out you know the Japanese market really well like hey like can you look at the numbers and see if they’re right and then feel we figure it out and so you know I’ll turn it over to Nick to sort of talk about that.

Nick: yeah as Dan said I we met day one at the Stanford GSB Business School we were we both sat through Charles Lee and just Petrovsky’s classes together and but prior to Business School I had a sort of a circuitous route I was in the Marines as an infantry officer after graduate school studying philosophy in England and then following that I went back to teach on faculty on the political science faculty and then I went to business school where I met Dan.

And after business school as Dan said I joined Goldman and among a lot of other things I had a little bit of coverage of Japanese clients essentially because I had a background and it was my minor and I’d spent a lot of time there both the military and on my own and Dan came to me I’m on the Japan Brian our current partner who joined it to begin this year full-time he they had been working on the out-of-sample replication test in Japan. And Dan called me one day and essentially said told me hey he had submitted the results of the out-of-sample replication test to the journalists covering him at the Financial Times and they wrote back and told him the data must be wrong because the volatility was way too low.

Dan kind of called me after checking the numbers and said hey this this looks like it really makes sense I checked the numbers there right and so we spent about eight months going back and forth trying to figure out how the heck it was possible to get a Sharp of 11.2 on a long only strategy in Japan for a levered small value and in a nutshell our specialty at Verdad is we invest in small cheap and levered companies generally very high free cash flow yield that that that resemble the quantitative characteristics of a 1980 LBO.

And as Dan was explained the number one risk control concern he has in the US or the European market is bankruptcy, avoiding bankruptcy and there’s a variety of risk control rules he can use to do that. But if you can figure out which companies are going to pay down debt versus which are going to have solvency issues within the universe of levered companies then you have the golden key to disaggregating the future returns of levered equities.

Now that’s very different in the Japanese environment because it’s the one country developed market country with the lowest bankruptcy risk and publicly listed equities there was one company last year went bankrupt out of 3,500 public listed equities and so if you take our kind of niche approach to levered equities in markets with high-yield debt more in high-yield debt markets in those geographies and you transition it over to the even more niche application in the Japanese environment.

The risk profiles of the outcomes on that are just radically different and there’s a marked variety of reasons why that phenomenon is so unique in Japan and why

that financing backdrop and exists but it’s just it’s one it’s one of the best environments to execute our particular nice strategy and internationally.

Nick M: so you guys have a global investment focus I’m curious as to what proportion of your fund I guess would be in Japan and then also to spin off of that what I guess are the underpinnings as to why I guess culturally and financially your strategy tends to work so well in the country of Japan.

Dan: yes in terms of we have we have two funds we were on a global fund and a Japan fund and the Global Fund is a third Europe a third North America and a third Japan and essentially because the correlations are relatively limited between small value stocks in Europe Japan in the U.S. that that provides a wonderful diversification benefit and it’s really nice to combine three less correlated return streams.

But you know we discovered is that Japan you know for the reasons the Nick described is and he can go into sort of the most attractive of those markets because if the dramatically lower risk and so we launched a dedicated Japan fund which is obviously 100% Japan and that fund in just a few months it’s actually grown to be the same size as our global fund so and Nick talk about sort of why Japan is so special.

Nick: so the bankruptcy is obviously a huge part that is just if you can reduce the aggregate probability of bankruptcy and a portfolio of levered stocks you essentially cut out the entire bottom quartile of performers in that portfolio.

So as whereas in the US or year up where they do have high-yield debt markets you’ll see dramatic bottom quartile results relative to a top quartile that dramatically outperforms the market in levered equities.

Now in Japan we see a similar upper quartile performance not quite as extreme but the lower quartile is actually has both quantitatively and what we’ve seen in live trading is is actually reduced risk relative it tracks the small caps in general or the small-cap index in Japan which has less volatility than the Nikkei or the topics.

And so that makes it just a very unique application of our strategy and then the other reason which we’ve tried to prove quantitatively as to why the strategy of back tests so well and seems to be working quite well in live trading. Is the really unique thing about Japan is from any investor who’s looked at it and everybody knows this and it’s been the strategy that every activist fund has tried to target in Japan.

Japan is the worst capital allocation market internationally from shareholders perspective whether it’s improved marginally in the last few years it’s a bit of a drop in the bucket. If you just benchmark the average cash used by Japanese companies as a percentage of revenue to pay dividends or do share buybacks or various other things that could be beneficial to shareholders its just way lower in Japan on the whole.

And so every fund especially the activists over the last 20 years who have looked at this data have said aha this is an opportunity if we can either select the companies that are going to be shareholder friendly with in Japan or get management to change their ways and be more shareholder friendly than we’ve cracked the code of one of the most inefficient markets from a shareholders perspective.

We agree with the exact same problem in the Japanese environment is that everybody else recognizes we just don’t think from the track record of most activist funds in Japan that the execution is its death certainly doable but it’s much more difficult to come in as a foreigner or a gaijin a westerner particularly and convinced Japanese boards to change their philosophy of how they of capital allocations for shareholders.

And so what we do and what we found quantitatively as well as if you take the universe of levered Japanese firms and compare that to the majority of Japanese firms that are have very cash heavy balance sheets. We generally see better capital allocation behavior from a shareholders perspective within the subsets of the market that is levered ie that’s the only universe we really select from in our fund.

And so in a sense the other kind of driver of our returns other than the reduced bankruptcy rate is the fact that the companies we select from are being supervised by the banks not to hoard cash on the balance sheet or invested in different projects whether it’s M&A; pipe dreams or empire building at the expense of shareholders.

Our companies generally want to pay down debt and they don’t have the opportunity to squander the corporate the company’s cash for purposes that are not in the interest of shareholders.

That is that’s an incremental reason I’d almost look at our quantitative strategy as a form of passive activism in Japan so that that’s one of the things that makes it particularly unique in that environment as well.

Nick M: this idea of capital allocation is really fascinating when it comes to your strategy because outside of that I guess core three concepts which are size valuing leverage a really close fourth would be the propensity to pay down debt.

I’ve done some reading and I see you guys have done work on how to predict what companies are going to pay down debt in the next year and in the years after that so can you talk a little bit about that predictive procedure I guess?

Dan: yeah and size value and leverage I mean in some sense are all contributors two main driver or returns be levered right I mean there are almost they’re the legs of the stool and the school is debt pay down that’s how we make money and way if you if you think about it conceptually right the way to make money is for things good to go the way to make a lot of money in investing is for things that go from really bad to only kind of bad.

If you think about buying really cheap companies that have a lot of debt on the balance sheet that then pay off their debt right they’re sort of naturally getting better they’re less likely to default and their financial health has improved and if they pay down a hundred million of debt just capital structure theory says that equity accounts should increase 100 million if Medagliani holds so you should get many benefits from that pay down. and in effect in reality if you think about investors who are focused on dividends or buybacks right it’s great to get money back but deleveraging is more beneficial than dividends or buybacks because in addition to you getting the money back or at least by proxy through the pay down of the debt the equity is going up you get all these other ancillary benefits of the improved health of the company.

And what’s also really cool is that well everybody can calculate a dividend yield right you can calculate them who’ve share will do if you’re do it for you know very few people can actually calculate a deleveraging yield even though it’s quite simple you just take the amount of debt a company paid off in the past year nope divide it by the current market cap and that’s deleveraging yield and we’re really buying companies that have a deleveraging yield of 15 or 20 percent and so these are companies that are paying down a lot of that fast and what we found is that we can predict deleveraging really well it’s not as predictable as dividends.

But it’s a heck of a lot more predictable than earnings growth and the simplest way if you start with what are the one of the what how do you how do you predict the leveraging it’s very simple you so how much debt did they pay down last year and that’s going to be your baseline for how much they’re going to pay down in the next year and there are things that are going to color your projection like basically more profitable companies are more likely to pay their own debt and less profitable companies.

Companies where the interest cover ratio for example is where they’re great interest coverage ratio much more likely to pay down debt right anyway any metric that looks at cash flow generation relative to the amount of debt or relative to the amount of equity it’s going to improve the likelihood of debt pay down. I’m just again it’s just mechanical all right you have to generate cash to pay down debt and so you look at the ratio the cash generation the amount of debt outstanding the amount of equity outstanding and that’s how you figure out how much debt is going to be paid down than what the magnitude of the impact that’s going to have on the equity valuation.

And what we’ve done actually to improve our predictor of accuracy as Brian is our director of quantitative research took all the financial data and from 1965 to 2013 I believe and did a machine learning algorithm audit and they said predict the likelihood of debt pay down one year forward based on one year ago financials.

And we found that we can get to about 70 percent accuracy without machine learning tool and it’s built on a lot of the same the key drivers of it are the ones that described we find that by using that sort of Bayesian model.

It really enhances our decision-making ability and what’s really cool is that it’s a very like if you look at our at our back tests right the companies that we predict are much more likely to pay down debt you end up predicting that paying down debt and they end up paying down more debt and their equity returns are higher so there’s a direct sort of logical connection with me.

And what we’re trying to do and what ends up happening that I think is sort of for us the sort of a most satisfying thing to see.

Nick M: when it comes to quantifying the other three main factors in the strategy size value leverage. How do you guys compute those factors?

Dan: yeah so I think in terms of now size is size matters in some places and not in others and so it’s one of our less important variables.

but when we would think of size both in terms of market cap and in terms of traded volume and in some cases traded volume it’s actually a better predictor than eyes like the throat stocks that are less paid attention to lower turnover and in the US and Japan at least are more attractive in Europe it’s a little bit different.

But the ones that are really at the core our strategy our leverage value and then probability of debt pay down or historical debt pay down. We calculate leverage very simply as net debt to enterprise value and we want a higher percentage leverage. We calculate value as enterprise value divided by EBITDA so we’re looking for low multiples of EBITDA I will also look at other multiples like EBIT multiples and price-to-book multiples to add some nuance to the value signal.

But what that combines to lead you to is companies that have roughly in our portfolio state trade at six times enterprise value but have about three times net debt to EBIT and that’s sort of the sweet spots for our strategy and broadly from there obviously if we can get if we can buy stuff at four times EBITDA which we can in Japan but it’s hard elsewhere and we’d prefer to do that and if we get a higher percentage leverage we’d like that.

But the thing with and then of course we want a deleveraging yield so we want not only are they deep and levered but they’ve been paying down a lot of that and the quantum of debt paid down is high relative equity value and the amount of debt they have on the balance sheet so all those things work together.

We’ve also found there were a ton of which we should get into it separately a lot of ways to sort of mitigate risk in that universe because if you think about if you’re buying the smallest cheapest most highly levered stocks in the world which is what we do. You’re also going to pick up a lot of stocks which are on the path to bankruptcy and so you have to really focus a lot on how to control for that risk and not that you can’t just buy the smallest cheapest most highly levered things you’re going to get too many dogs in there so there has to be other elements of your process as well to control for those risks but that’s sort of the core of the engine.

Nick M: that’s a nice segue into what my next question was going to be because when it comes to the leverage factor there has to be diminishing returns buying companies within a 99% net debt – EBITDA though that’s probably a recipe for disaster on average.

So I guess how do you mitigate the risk that comes specifically from the leverage factor but also from the strategy as a whole?

Dan: sure so a few things so first debt so sort of consensus academic wisdom right is that that is bad right that the more debt you have the worse your equity returns.

And there is a logic to that and there is empirical evidence to support it and we would agree with that and if you think about debt relative to profits debt relative to cash flow or debt relative to EBITDA the more debt you put on the balance sheet of a company the higher the risk of bankruptcy the worse the equity outcomes are going to be.

However if you think about debt as a percentage of the capital structure just logically right if you if you’re running a portfolio that’s 0% levered for as a portfolio that’s 50% levered the 50% levered portfolio just basic capital structure theory should do twice as good is you know your equity is now levered one to one as opposed to being completely unlevered and the more leverage you can get the higher the dispersion of outcomes are going to be right?

If you can buy some that’s 90 percent levered and that has just a 10 percent equity sliver your dispersion of outcomes in that name are going to be very high and in equity markets high dispersion is very good because you can lose your money only once and you can make your money up six or seven times.

And so you then one of them think about right is if you have those two sort of competing impulses right you want high percentage leverage and you want low absolute leverage and that’s why we talk so much about value and leverage interacting right it’s so important to buy really cheap things that are very what nicely levered and percentage basis but where the absolute leverage of level of leverage is low.

And so that’s sort of how we think about the just the general problem with leverage um the other way to reduce the leverage as Nick will tell you is just go to Japan where there’s no bankruptcy risk at all so at the more depth who cares it doesn’t make any difference which is one of the reasons that we love and so on when you then think one of the ways then in addition to that I’m to control for the risk of bankruptcy which is other than just going to Japan where there isn’t bankruptcy what are the ways in which you can control for bankruptcy.

And that’s what we spend a lot of our quantitative research focused on and a lot of our screening and some of the biggest predictors are sort of interesting so of course there’s credit rating if something is a C credit rating it’s very likely to go bankrupt and we and will basically take the inputs into the credit ratings models and we run those ourselves so we even if slang isn’t rated we generally know what the rating should be and we’ll eliminate anything that C has a C rating.

And the next one of the interesting metrics that works really well in the US and Europe is shorting. so shorts are smart if shorting a small valued stock it’s looked really cash generative chances are they’re doing so because there’s a pretty good knowledge about how fast the business is operating and the probability of bankruptcy. And so if you eliminate most highly shorted stocks from your universe you have dramatic reductions in risk and dramatic increases in returns.

And so but if you think about those is probably two of the tools and then I think the third tool is just carefully watching momentum that stock prices do predict future fundamentals and so the stock is down 50 percent in the last six months chances are next quarter isn’t going to be too hot. And so as you’re buying that stock you want to be buying that slowly to make sure that you’re you’re getting all the latest information you’re not catching a falling knife.

And so those are sort of the major risk controls we use which first are sort of things that you can calculate based on historical financials second will be paying attention to short interest and then third using momentum rules as we trade such that we don’t sort of catch these falling knife type scenarios.

Nick M: this idea of the strategy being derisked to an extent in Japan is really fascinating to me and I want to ask whether or not the essentially 0% interest rate policy there has any impact on that?

Nick: yeah so that’s actually a really fascinating question I mean that’s been in place since 1998 the Japanese really pioneered it.

You would think it would and one of the number one questions we get is what if that changes and certainly that would probably have some impact although the caveat I would give to that is I don’t think what most people realize is Han is so cheap relative to the U.S. the Nikkei trades at about a little over eight times EBITDA whereas the SP try around 12 or 13 times and our companies are trading somewhere usually between 4 to 5 times see but on average and so at that at that those valuations you really only need one to two turns of debt on a or two terms of debt of two times even a worth of debt on a four times EBITDA company to get a 50% levered capital structure well two terms of debt is not that much debt at all your average LDO is about six terms of debt.

I think where people might miss the boat on this question about what if interest rates did increase they would have to significantly increase to cause any solvency risk to Japanese companies even just assuming they operated in the same way that US companies do with refinancing ability to refinance with the banks over there assuming that it would have to be a significant increase in interest rates for the interest coverage ratios to deteriorate significantly enough to cause solvency risk.

And that’s our average company plays about 75 basis points on the debt they get from the main banks in Japan and you know that is it’s significantly lower than the US even if the Japanese import rates went up significantly even three hundred four hundred five hundred basis points. These are still mildly levered companies on an absolute basis that happened to be cheap enough to match the capital structure leverage ratios than a typical LBO would.

Nick M: is there an argument to be made for the other side of the coin so I guess higher interest rates would incentivize Japanese capital allocators to pay their debt down more quickly which would strengthen the impact of your strategy.

Nick: yes in theory although you we are we are never unsurprised when we visited Japanese companies to find the capital allocation logic of the CEOs or the CFOs of the company it does not match what you would expect from a Western perspective.

In business school there’s an optimal capital allocation theory that at a certain amount of debt with certain interest rates your weighted average cost of capital is X and it would ideally make sense to take out more debt if interest rates are more favorable or take out less if there not in Japan.

This is just for 90% of corporate management teams in Japan this is especially in the small cap world this is not the logic that’s going through their head will visit the companies and ask them hey you have you have two terms of debt you’re not that levered you’re paying 75 basis points on it do you want to pay down debt?

Oh yeah we definitely want to pay down debt and we say well well heavens why would you want to do that it’s essentially a free credit card from the bank or are they being mean to you and they say oh no we violated every single one of their covenants two years ago and they offered us more debt at a lower interest rate.

We’re just going to and we’re from and we are the natural question for us going through Western business school learning optimal capital allocation is well then why the heck do you want to pay this debt down so much.

And it’s it usually comes down to a lot of the same philosophy and it’s not we’re not making a judgment to normatively judgmental claim here but a lot of Japanese corporate management is much more concerned less so with shareholder returns or optimal capital allocation and the longevity of the business or the happiness of the employees or this the impact they’re making to society.

It’s much less I think aggressive financially then your typical US CEO or CFO would be and so we see a lot of kind of bizarre behavior where I don’t know that that relationship would necessarily hold the same way it would if you applied interest rate change to US CEOs.

Nick M: can you maybe give us an example of what a company in the Japanese portfolio would look like?

Nick: sure our typical come just statistically and then I’m happy to go into an example or two but statistically our average company is today is about four point eight times EBITDA about 4045 percent net debt to enterprise value we hold about 40 of them 35 to 40 at any given time the average market cap is going to be somewhere around seven hundred million although the medians lower there’s because there’s some bigger ones in there and typically they pay down about seven percent of their net debt balance from the previous year.

That said they’re pretty they’re spread out we do everything except for financials banks and then we generally will avoid real estate it’s just a general rule of thumb that Dan and I have is if we don’t really understand how its valued and it’s an anomaly in terms of valuations from the rest of the universe of companies in that world we stay out of it if we don’t understand it.

I think banks and to some degree real estate firms fit that so what you’ll see in our universe in Japan particularly industry concentrations a little bit different especially in the cheap realm you’ll see more so the Japanese auto supply chain.

It’s very cheap industry groups near the top of our looks most attractive at least to a computer but we apply some reply apply limits to our industries so you’ll really only see about 10% of any one industry on the lower order so like auto supply chains grocery consumer retail chemicals those sort of classifiers you won’t really see more than of the fund any more really than about 10% and so it’s a very diversified group of different industries excluding financials and mostly real estate you’ll see within our portfolio and I think you know might be.

Dan: it might be worth talking about just to illustrate I think some of them perhaps some of the most people often ask how our companies became Leppert right which is always an interesting question and Nick I thought maybe there are a few different examples like Ishihara or EMIA or there might be you know worth talking through or maybe one of the ones that has done some horrible capital allocations those are probably the three most common acts.

Nick:Yemija was one of those we were invested in at least from the beginning but that was one of the smaller names but a very interesting one that was a liquor and restaurant roll-up they were a former Carlyle portfolio company or at least a liquor store they bought out were and so they were levered after being under a sponsor in Japan and that’s you know that’s one reason why a company it might have been might be levered at the time we’re looking at it they just get out from a sponsor or private equity ownership.

Another one was other reasons they might do it as they made just a horrible boneheaded capital allocation decision one of the companies a chemical company were involved in not Ishihara but they decided to build a factory in Malaysia on an island where nobody spoke local language and they couldn’t get any Japanese people to and it was just one of the worst kind of boondoggles in the it was completely unprofitable and they took out a lot of debt as a result of it and had vowed you know to never do that again.

Ever since that so you’ll see I think about I would estimate about a third to 50% of our companies have made some sort of really bad capital allocation decision in the past that it was a result they needed to take out either to execute that capital allocation decision they need to take out a loan from the bank or subsequent to execute to that project they had to take out a loan to sustain themselves in the interim.

And so there’s a lot of I think half the companies we go and eventually meet with it’s more like we joke that it’s more like walking into a confessional than to kind of a corporate pitch and half of the discussion is we’re sorry for what we did two years ago we’re very focused on delivering there’s a new CEO and we you know we learned our lessons from that decision that resulted in our leverage now.

A more Ishihara like you said it was a massive environmental liability that that they had to take out debt to get through so those are all the various different reasons why but you usually looking forward they they kind of regret what happened in the past.

Nick M: with this focus on Japanese stocks how do you guys think about currency risk do you hedge it or do you leave it unhedged?

Nick: oh we don’t are one I think our investors if they if they have strong directional views on the yen they can choose to hedge.

So one is just practical it’s easier for them to do that and to I mean we’d we don’t want it hedged in Japan particularly if there were any other country it might be a different debate.

But we found a very there is a very long period of time and yes it could break but there’s a strong inverse correlation between equities in the in dollar rate such that when a U.S. dollar investor is doing well on currency usually Japanese equities are doing very poorly and vice-versa so when we test this over very long periods of time being unhedged in Japan for FX has significantly reduced the volatility and the draw downs of the strategy.

And you know yet yes it could break that that’s definitely a possibility and we don’t I don’t I don’t necessarily know that it would be wise to bet the strategy on that happening but for the last 20 years or so and you know subsequently during live trading just in February this was following the rhyme of history when it comes to Japanese FX was as at least been the right decision and so it’s good to see it working in real trading as well.

On the dailies it’s very predictable you can almost run in a regression of the Nikkei performance and just include the variable of how well the S&P; 500 did and the FX movement explained about 90% of its daily with trading movement and then on monthlies and yearly x’ there’s also a pretty strong correlation.

So we do we definitely like the volatility damping characteristics of being unhedged for FX in Japan.

Nick M: that is fascinating I had no idea about that phenomenon. What about other currencies?

Dan: we don’t hedge other currencies either they’re not the end has that sort of special flight to safety dynamic which is so helpful other currencies don’t necessarily have that but our view is that the currency exposure is part of the diversifying benefits of investing abroad. And since we don’t have a directional view on currency the cost of hedging are probably worse than the benefits to us.

Nick M: I want to circle back now and talk about the operational implementation that private equity managers tend to claim when they talk about the sources of the returns. So I’ve read that you guys have done a lot of empirical research into whether or not private equity managers actually have the capability to improve the performance of their companies. can you talk a little bit about that and why it led you to believe that private equity performance actually comes from size leverage of value?

Dan: sure what I think first of all there’s no magical way to improve company’s operating performance I mean if there was a playbook everybody would use it I mean companies are just complex things there’s no perfect strategy it’s not like if you’ve gone to Harvard Business School you’re granted the magic wizard wand and then any company you walk into magically improves EBITDA margins by a 4%.

It’s just not the way the world works right things are too stochastic and complex so I think that the idea that private equity firms would have some sort of systemic operational improvement right that either the companies that are blocked by private equity start to grow faster than other companies so their margins systematically improve.

My sort of a priori hypothesis would have been that seems unlikely especially since most of the people who work in private equity are former investment bankers not company operators right there that this is not like the VC world where the VCs are all entrepreneurs right.

Most private equity guys are investment bankers and do you want your investment banker running your laundromat or something probably not their skill sets or doing deals capital structure not necessarily margin improvement or revenue growth or product market fit or whatever.

But to test this what we did is we looked we basically build a data set of every private equity deal that had been financed with public debt and what’s special about public debt is that or bonds essentially is that when you issue a bond you have to report the financials prior to the bonds being issued and you have to report regularly to your bondholders.

And so essentially the private equity deals are fun at finance public debt have financial level data both pre and post-acquisition and so you say well let’s look at all these transactions and see what the difference in operate electrics are pre acquisition and post-acquisition. And what you find is that on average for a private equity transaction revenue growth slows margins are essentially flat and so there’s not a huge difference on those metrics.

But what does happen unsurprisingly is debt goes way up interest payments goes way up and capex goes down and so basically the goal of private equity is to effect a change in capital structure to enable a in essence to create these levered opportunities.

And any operational improvement quote-unquote that follows from that is largely I think this sort of discipline of debt idea right that by having debt it means that you won’t spend money on stupid capital expenditures that you will be more frugal on costs.

I think that broadly most American companies are running pretty efficiently pretty lean and mean already so there’s not a lot of low-hanging fruit they’re just putting debt on the balance people so there is in Japan that’s another issue probably yes the company is not going to invest as much in capex and statistically we see that when they’re levered and the quantitative research suggests that most capital spending is is bad or essentially the higher the investment though the worse the equity returns. So there is some logic to that.

But none of this is none of this is flowing from anything other than the change in capital structure there there’s no there’s no magic wizard wand that the private equity some secret book held in the bowels of Blackstone that reveals how to make company is much better than nobody else knows or understands.

Nick M: you also mentioned earlier and I forgot to ask this question at the time. But massive inflows into private equity have brought up valuations and kind of ruin their returns so with that in mind would you say that the Verdad strategy is capacity constrained as well?

Dan: absolutely we think that broadly every asset manager makes a choice between making Ferraris and making Toyotas Nick and I and Brian you know we want to build Ferraris we want we think of ourselves as craftsmen we loved we loved building really beautiful things that work really well and we’re okay with not producing that many of them.

We don’t want to sort of mass-produce something in our view is that mass-produced active products you know the sort of large capacity active products or have a really hard time competing with index funds.

Whereas the opportunities for investors for active management we think is in the niche and the unexplored and the off the beaten path and you think about what we specialize in which is levered companies which nobody else really does and then specifically in Japan which really nobody else does. we are about as well off the beaten path as you could possibly get and our view is that we want to stay in our little niche which we know really well and produce excellent return strings.

But we’re never going to manage 50 billion dollars we might never even manage a billion dollars our strategies that are so capacity constrained but we really love doing that we love what we do we love proving that our ideas work and live trading and that’s I think intrinsically satisfying over and above the sort of reward of managing billions of dollars I think it’s not necessarily our goal.

Nick M: this whole idea for Verdad has been the culmination of really like a decade of work almost by now and I’m curious is there any other field of research that has you excited right now that could potentially be a new strategy for Verdad in the future.

Dan: we do we spend so much time on every little aspect of our strategy so if you think about what today Brian is working on replicating all of our work in Europe and Nick has been working on essentially looking at each quarter when we trade how much do we want to rebalance how does the rank have to be to sell versus how high how does how do those dynamics affect trading and so I think we’ve got a long ways just on optimizing our current strategies all these are such important research projects to work on.

I could see us launching a Europe dedicated fund I think that’s something that we definitely have on our roadmap but other than that I think we really want to sort of stick to our knitting and focus on things that are narrowly within our circle of competence. there are other things that I love to read them out I love reading about and talking to my friends that do short selling I find it endlessly fascinating.

but I look at the level of expertise they’ve put in decades of research so I’m good at what they do I don’t see us putting a decade in to develop a strategy that’s not directly continuous to what we do.

Nick M: this is a nice segue to talk about learning because I love asking people who work in intellectually stimulating fields like you two both do about what their learning process looks like and what they like to read.

I guess I’ll start I guess with a question from Ted Seides– that he likes to ask people and that is what research do you like to read that people would be surprised to find out that you would read or it doesn’t have to be research it could be a book or a periodical or what have you.

Dan: well this question over to Nick because largely Nick is actually a was a professor prior to working Verdad and so for the past two years or so I’ve been on the Nick Schmitz philosophy boot camp reading list. I’ve just been reading things that Nick has been recommending but his reading list is pretty interesting so I’ll turn it over to Nick.

Nick: sure and with the caveat that I’m definitely an extremist on this so it’s not definitely I wouldn’t recommend that it’s the way to go with everyone. But I was used to teach and the students would turn in papers and they’re one of the first things you’d check is the sourcing of what they’re where they’re actually getting their information from whether it’s Wikipedia or some secondary opinion article or actual primary data.

And inevitably the most original papers and the most insightful conclusions were directly correlate with the amount of primary sourcing that the students used its own a surefire thing and I found the you know some of the worst papers where they just looked up a their favorite opinion journalist and the column that happened a really related in a popular paper and just repeated what they said.

I actually try to lock out most of the secondary source opinion pieces although it is helpful to not reinvent the wheel on stuff but I generally err almost exclusively to primary sources and for the quantitative overlay portion of that that’s data.

I do spend a disproportionate amount of my time looking at Bank of Japan data looking at bankruptcy rates looking at the entire universe of Crisp or Bloomberg or Capital IQ data on the market as opposed to reading what somebody wrote last week or put in a sell side pitch deck that was popular and circulating around.

I find we come to the most unique and interesting conclusions when it’s driven exclusively by the primary source data in terms of reading that’s I’m also I think probably a bit of an outlier there I have a general rule that Dan makes fun of me that I try to only read things that are at least fifty years old I have a theory that that 99% of human wisdom has already been captured and explained far more eloquently by people that lived prior to the 1950s and 60s than those that write today although there are rare exceptions.

And so inevitably Dan will send me a new article or somebody and or and I’ll shoot them back a version of one of Plato’s dialogues that said the exact same thing and I thought it said it better and I think that probably annoys Dan.

Dan: but the contrary I’ve got literally on my anthology that Nick has been making me read which starts with Aristotle and Plato and goes through all the major thinkers and if I find it fast I mean we’ve read under Nick’s tutelage Isaiah Berlin and who I loved and conception of pluralism and Aristotle I thought was fascinating and Karl Popper is just an by a band on scientific method.

Gosh I mean it’s just I find that the and I think the philosophy is so fascinating because in some sense right investing is a game of meta-analysis not analysis right it’s not about necessarily how well do you analyze company X or company Y.

It’s much more about how do you analyze the company relative to how everyone else analyzes it or how does your worldview shape your a whole set of actions you know what are the rules that dictate your behavior and so I think reading philosophy is a really interesting way to push yourself to think well how do the great thinkers think about these questions which are so similar in some ways to investing about how to set rules for life or rules for living and how do those apply to investing I made something that I’ve been thinking a lot about.

Nick: and I might add as a deep value investor what our firm does is essentially contrarian a nation in nature we’re at its essence we’re betting against the overly pessimistic consensus views on some of these companies.

And so I think it’s very helpful to study what that consensus view is just to understand it but in terms of actually predicating your investment decisions on it I would be more alarmed if we thought similarly to everybody else in the market about the companies we owned.

Nick M: that’s interesting thanks for sharing a few other questions that are more in the fun category that I’d love to ask people are.

If you had to retire and work outside of the field of finance what do you think your dream job would be?

Dan: well I personally love what I do so probably is my dream job but I’ve I think I think I wrote a history book about a slave revolt in in New Orleans and I loved every process but every part of that process of sort of the deep archival historical research the constructing that the narrative. And I think I probably would love to retire to some cabin in the woods somewhere and as long as I had access to a really good library and research and write and I’d probably do more on American history.

Although recently nick has gotten me so jazzed about philosophy that maybe I’d be tempted to write some sort of philosophical thing about American history but somewhere in the intersection of American history and I think there’s a cool field that I’ve been reading in it’s called Cliometrics, which is essentially the application of quantitative inquiry to the study of history.

It was really pioneered by this guy Douglas North who’s a really brilliant guy. But I think there’s a lot there to subjecting historical claims to quantitative evidence and to say gee I know that everybody thinks that for example there was something called the Red Scare where people panicked about all these communists in the United States. But then when the Soviet archives opened turned out there were a lot of communist spies so I think there’s that it would be fun to write something contrarian in American history of comparing sort of the narrative that’s been spun to sort of what the quantitative or empirical evidence in reality suggests so that would happened.

So I think that probably my dream job outside of investing I don’t know what about you Nick?

Nick: I used to be in the Marines as an infantry officer and that’s kind of that was a dream job for me and there’s not really much else that compares to that outside of the Marine Corps I mean it’s just an incredible peer group and a unique profession where you’re kind of given at the age of 23 an amount of responsibility for both people and strategy and strategic thinking that would be hard to reach at a similar age group anywhere else.

But unfortunately it’s a young blood organization and once you’ve passed 30 it’s your knees in your back about so you have to find something else elsewhere I was also a teacher and I loved doing that but the I think the more frustrating thing with publishing in certain academic fields is you can write your ideas and your hopefully their right but it’s not necessarily a sure shot that you’re going out impact the you’re going to be able to foresee the fruits of that labor.

And you can also be right and it have very little impact and I thought I found that was kind of frustrating in my initial attempts to publish on constitutional law and then so I thought after business school what is a profession that kind of matches my demeanor and my desires and I found I found that being in a small niche actively managed hedge fund portfolio manager it’s remarkably similar to the Marines and a lot of aspects in the sense that as an officer there it’s extremely high-risk and high-reward you’re given complete discretion you have to engage in a significant amount of meta-analysis of both your competitors and the people around you,

And ultimately or you’re responsible for the bottom line of all of your bets and you can see the fruits of those decisions in in real life and I found that’s a pretty unique thing in the hedge fund space which is is difficult to find in in like Investment Banking which I was doing before or in academia and so as far as the options are out there that for me today that don’t involve carrying a eighty pound pack I’d say the hedge fund is a pretty good fit.

Dan: I know if Nick ever gets too bored or frustrated we’ll just open up the Verdad Afghanistan office.

Nick M: another tangentially related question is if you had to stop managing your own money you could continue to work out for Verdad just not with your own money and give your money to an outside investment management firm or individual or could be an individual stock. Who would it be and why would you choose them?

Dan: this is sort of my the way that my father raised me actually my father invested all of his savings in Vanguard starting in the 1970s when he graduated from law school and so I confess to being a lifelong fan of Vanguard and Jack Bogle and I would say that if I passed away and there Nick passed away and managed our strategy I would tell my family to put all their money in Vanguard.

Nick M: what about you Nick?

Nick: in terms of investment strategies I think the both what we recommend to our parents and others is the vast majority should be in passive products. none of that that said in terms of who I’d give my money to I mean any day you ask me I might have a different answer and you’re asking me the day after tax returns.

It might be particularly biased this day to fund some sort of organization that like Americans for Tax Reform United States government my answer any other day than after mid-April is would be a different charity probably.

Nick M: okay well my last question I asked this to everyone is. If our listeners want to learn more about Verdad and what you guys are doing where can they find you and learn more?

Dan: yes we write actually a lot we write a weekly research piece and if or if your listeners would like to sign up for our weekly research piece they can either find the sign up link through my Twitter profile which is @verdadcap or we can also send you a link Nickolas to include with this podcast but that’s the best way to get to know us and learn about what we do.

Nick M: awesome well thanks for your time today guys it was a great conversation and thanks again for being on the show.

Dan: our pleasure.