Portfolio Elephants (Expanded)

The Credit Strategist Blog

Bill Ackman made a very interesting and important point in a CNBC interview this morning. When Andrew Ross Sorkin asked him about his views on Harvard, Mr. Ackman said that the university is not in as strong a financial condition as it might appear for two reasons. First, it has $8 billion of debt. Second - and this is the point I want to highlight here - he said the $53 billion reported value of the university’s endowment is highly questionable because a large part of the portfolio is invested in non-publicly traded assets like real estate, private equity and private credit that he believes are significantly overvalued. He noted that Harvard is currently shopping $1 billion of its private equity assets that he expects to be sold at a 30-40% discount from its carrying value. He also noted that as the manager of a hedge fund and a publicly-traded vehicle, if he were to sell assets at a discount he would be required to re-value his entire portfolio downward. For some reason private equity and private credit managers aren’t held to the same standard.

Mr. Ackman is pointing to the elephants squatting in the middle of large private equity and private credit portfolios. Trillions of dollars of mismarked assets are sitting on the books of private equity and private credit firms and their partners (i.e. institutions like Harvard). Many of these firms are publicly traded while their assets are not marked correctly. Just 40% of direct lenders reporting to the SEC use third-party loan appraisers according to Private Debt News Weekly and 40% of private credit borrowers were cash flow negative at year-end 2024 according to the IMF. I expect similar percentages private equity-owned companies are in similar straits. Publicly-traded PE stocks lost 30% of their value since their post-election peaks last December but are still trading based on inflated asset valuations. Imagine what will happen when the next debt crisis hits (and it will).

Allowing rampant mismarking of positions by managers weakens rather than strengthens credit markets where levels of trust are already at abysmal levels due to creditor-on-creditor and borrower-on-creditor violence promulgated primarily by private equity and private credit firms. The harsh verdict of the market will eventually set things straight while managers keep hiding the truth with NAV loans and other financial shenanigans. Digging deeper is not a strategy. And looking the other way is not effective financial regulation.

Two data points strongly suggest that private equity is no longer a compelling investment. First, the S&P 500 grew by more than 5500% since 1980. The second is that Berkshire Hathaway’s shares skyrocketed by 5,502,284% since 1964 (vs. the S&P 500’s rise of 39,054%). These returns illustrate the power of compounding without the drag of the high fees that private equity (and hedge funds for that matter) extract from partners.

But private equity’s best returns are in the past. In the early days of the modern private equity industry, high investment returns justified high fees that shifted an estimated 25% of gains (on a 2/20 fund) from investors to managers. But today returns are not particularly high and are falling due to the inability of private equity firms to sell companies and return capital to their investors. As a result, the value they are providing is no longer commensurate with such high fees. When these lower returns are risk-adjusted for illiquidity, concentration risk, leverage, and other factors, they look even worse while the fees charged by these funds simply appear egregious.

It is extremely difficult to conclude that private equity is a better alternative than buying the S&P 500 ETF (SPY) and holding it over long periods of time. The latter alternative provides liquidity, low fees, diversification, and low leverage (though there are varying degrees of leverage among S&P 500 companies). Retail investors should keep this in mind as their investment advisers solicit them for the opportunity to invest in private equity firms. They should remember that they should never join a club that wants them as a member.