It's a very one-sided deal.
Every year 40,000 people flock to Omaha, Nebraska to listen to Warren Buffett and Charlie Munger share their wisdom. And wise they are. 88 and 95-years wise.
This year they were asked about the outlook for private equity and ‘so-called alternative investments’. Buffett is not excited, to put it mildly.
“The supply demand situation for buying businesses privately and leveraging them up has changed dramatically from what it was ten to twenty years ago. We have seen a number of proposals from private equity funds where the returns are not really calculated in a manner that I would regard as honest.”
He goes on.
“If you can raise $10 billion in a fund and you charge 1.5% and you lock people up for 10 years, you know, you and your children and your grand children will never have to do a thing even if you are the dumbest investor in the world. It’s a very one-sided deal.”
“It’s not as good as it looks” he says. Munger goes so far as to say, “They are lying a little bit to make the money come in.”
How can funds get away with lying a little bit? They get away with it because they report a return figure called an IRR – an internal rate of return. An IRR is not the same as an annual compounded return.
Preston McSwain recently wrote about this in a blog post entitled ‘Fake News’ that got a lot of attention online. He quoted some impressive return figures taken from a presentation from a leading private equity firm.
However, he goes on to point out that at the back of the 50 page plus presentation book in very small print were the words:
Think about that for a minute.
The returns quoted were not actually delivered to even one investor in the fund. It’s a quirk of the IRR calculation.
Preston writes, “IRR calculations assume that future investments will achieve the same returns as past investments. Even though it never happens in the real world, in an IRR calculation, realized cash distributions keep earning the same returns in the future for the complete life of the fund or private investment.
To drive this home, below is an illustration from the McKinsey study that warned about the “unrealistic expectations . . . [and] dangerous assumption[s]” that IRRs create.”
This is what Buffett and Munger were warning about.
It’s a bit like a runner projecting out their 100-metre sprint time onto a marathon.
The problem is private equity and alternative investments have an allure. They are sold as ‘exclusive’ and ‘private’ and ‘complex’. As Josh Brown writes, it’s about being part of the club:
But it’s not a club with equal membership. It’s skewed terribly. Unfortunately much of Wall Street is.
Matt Levine said something that caught my attention in a podcast recently. When asked about his biggest pet peeve, he replied:
“There is this constant theme of people who have bought a self-evidently terrible investment and then it turned out terribly for them. This thing that is clearly structured and risky and they went and said “I thought this would be good”, and then they lost all their money. And it’s frustrating. What I want in the world is for people to be better warned about that and then get no sympathy once it happens. You should divide the investing universe into sensible things and ridiculous things. And you can do ridiculous things. And ridiculous things are, like, most things. Sensible things are things like index funds. If you want to do hedge funds or whole life insurance or whatever you want, like fine, but the due diligence is on you and if it doesn’t work out then you can’t complain. I think that would be a better system. We are not there yet because people just aren’t given the right tools to evaluate that.”
The last sentence resonated with me. Surely part of the role of proper advice is to evaluate these things for your clients and steer them away from ‘ridiculous’ things and into ‘sensible’ things? And when I say proper advice, I mean advice from someone who is a true fiduciary, not a sales person.
Most people need someone to help them see through the sort of trickery inherent in sales pitches so that their wealth doesn’t suffer and they can continue to actually compound over the long-term.
That’s what I do. That’s what I am here for. It’s nice when you hear the Sage of Omaha agreeing with you.
If you want to get more into the nitty gritty of the IRR calculation, I recommend reading Howard Marks’ in depth piece “You can’t eat IRR” here.