Trym Riksen’s Post

READING TIP FOR EASTER 2024: Read Bullshit Easter holidays are great for thinking about bigger issues. So why not spend some time on bullshit? Here’s my reading tip for financial professionals who would like to absorb themselves in bullshit. In 1986, Harry Frankfurt (1929-2023) wrote «On Bullshit» (1). The American philosopher (2) said that «…bullshitters, although they represent themselves as being engaged simply in conveying information, are not engaged in that enterprise at all. Instead, and most essentially, they are fakers and phonies who are attempting by what they say to manipulate the opinions and the attitudes of those to whom they speak. What they care about primarily, therefore, is whether what they say is effective in accomplishing this manipulation. Correspondingly, they are more or less indifferent to whether what they say is true or whether it is false» (3). Professor Frankfurt drew a clear distinction between lying and bullshitting: «It is impossible for someone to lie unless he thinks he knows the truth. Producing bullshit requires no such conviction. A person who lies is thereby responding to the truth, and he is to that extent respectful of it. When an honest man speaks, he says only what he believes to be true; and for the liar, it is correspondingly indispensable that he consider his statements to be false. For the bullshitter, however, all these bets are off: he is neither on the side of the true nor on the side of the false. His eye is not on the facts at all, as the eyes of the honest man and of the liar are, except insofar as they may be pertinent to his interest in getting away with what he says. He does not care whether the things he says describe reality correctly. He just picks them out, or makes them up, to suit his purpose» (1). Though Frankfurt died last year, bullshit lives, does it not? Can you think of examples of bullshit in modern finance? Do we have too little or too much bullshit? Is there something like a tolerable amount of bullshit, or should bullshit be controlled like pests? Is it sustainable to produce and consume bullshit? REFERENCES: (1) Harry Frankfurt’s «On Bullshit» (1986): https://lnkd.in/d5xXKR9t (2) https://lnkd.in/dRJ674cH (3) Quote from Frankfurt’s «On Truth»: https://lnkd.in/dW68yfEj

PRIVATE EQUITY FIRM KKR SAY THEY BEAT BUFFETT 1976-2023 The second biggest private equity firm in the world, KKR, say they beat Warren Buffett’s investment record by a large margin. While Buffett made 19.8% annually since 1965 and 21.9% since 1976, KKR report that they made 25.5% annually since 1976 (1). “From our inception in 1976 through December 31, 2023, our (...) activity generated a cumulative gross IRR of 25.5%, compared to the 11.9% (…) gross IRR achieved by the S&P 500 Index”, KKR says. If you put $1 into Buffett’s Berkshire Hathaway in 1965, your dollar would have grown to $44000 dollars in 2023. By comparison, KKR’s 25.5% annual return would have grown $1 in 1976 to $54000 dollars in 2023. In other words, KKR say they have created more value since 1976 (48 years) than Warren Buffett has done since 1965 (59 years). And there’s more. According to KKR, private equity has lower risk than public markets (2), parroting Blackstone’s claim (3). The naïve investor may ask how it can be that KKR creates much more value than Warren Buffett. Is Buffett hyped up? The short answer is: Bullshit. The return and risk figures of KKR are what philosopher Harry Frankfurt described as bullshit in his legendary article “On bullshit” from 1986: “For the bullshitter (…) is neither on the side of the true nor on the side of the false (…) He does not care whether the things he says describe reality correctly. He just picks them out, or makes them up, to suit his purpose” (4). In 2019, Buffett’s late partner Charlie Munger commented on private equity business practices: “All they’re doing is lying a little bit to make the money come in”, Munger said. Buffett replied: “Yeah, that sums it up”. In 2008, Oxford professor Ludovic Phalippou described why IRR is irrelevant (5), and recently he commented on the KKR IRR figures (6). In a series of articles I recently documented why the low volatility (and risk) of private equity is an illusion (7). The real question is not if KKR has had higher returns than Buffett. The real question is why finance people tolerate bullshit. Why are the many PE people of integrity silent? What do You think?     REFERENCES: (1)  See page 19 in KKR’s annual report: https://lnkd.in/dypcZ43W (2)  See exhibit 15: https://lnkd.in/dNmqS9PK (3)  https://lnkd.in/dS2Fj2ux (4)  https://lnkd.in/d5xXKR9t (5)  https://lnkd.in/d5nay9Fj (6)  https://lnkd.in/dUEAneNK (7)  https://lnkd.in/dcPNzzKC #kkr #blackstone #warrenbuffett #berkshirehathaway #ethics #integrity #businesspractices #bullshit #sec #securitiesandexchangecommission

WOMEN’S DAY 2024: NORWAY SETS AN UNBEATABLE WORLD RECORD A post (1), from the Norwegian parliament Stortinget, shows a remarkable fact. Out of 10 parliamentary leaders (2) in the Norwegian parliament Stortinget, 10 are women. A parliamentary leader is the head of the representatives of a political party, a stortingsgruppe in Norwegian (3). In other words, out of 10 parties represented on the Storting, 10 of the leaders are women. What is special about this fact is that it hasn’t been a big issue in the media, as far as I have noticed. It feels normal that women lead in Norwegian politics, and nobody notices if the leader is a woman or man. The sex has become irrelevant, it seems. Still, the fact that 10 out of 10 are women is probably not entirely a coincidence. The probability that 10 out of 10 random persons are of the same sex, is 0.5^9=0.2% (4). Consequently, 10 out of 10 probably reflects the fact that Norway has had equality on the agenda for decades, or even a century. On 11th June 1913, the Storting voted unanimously in favour of universal suffrage - and Norway became one of the first nations in the world to have equal right to vote. I think it is a great accomplishment that Norway sets a world record in women representation in top politics. The fact that there is little talk about this unbeatable world record, before Stortinget made the March 8 post today (1), is quite remarkable as well. What do You think? REFERENCES: (1) https://lnkd.in/d_GBXHKv (2) https://lnkd.in/duxuztuC (3) https://lnkd.in/ddGXGeq3 (4) For the statistics interested, the balance between men and women in the Norwegian parliament Stortinget is 55% men and 45% women. The gap has been closing steadily since WW2: https://lnkd.in/dG2pSgsA

THE GREAT MYTH ON RISK-ADJUSTED RETURNS IN PRIVATE EQUITY Real-world private equity returns have been about the same as in listed stocks (1). However, often ignored is the fact that private equity has been significantly riskier. While private equity managers tell you that risk-adjusted PE returns have been very high (2), risk-adjusted returns have, in fact, been low. In a series of articles (3), I documented that about ⅘ of the volatility in securities prices can be laundered away by implementing varying reporting lags across funds, appraisal values and asymmetrical performance fees. Additionally, private equity indexes and aggregates are not investable. So you are exposed to relatively narrow private equity portfolios. This means that individual investors in practice are exposed to significantly higher unsystematic risk (4). The illustration shows what happens with risk-adjusted private equity returns when accounting for higher risk due to leverage, increased unsystematic risk and controlling for volatility laundering in private equity values. Risk-adjusted returns in private equity are substantially lower than people are led to believe by marketeers, and significantly lower than in public equity. Private equity marketing tells you that risk-adjusted returns in unlisted stocks are much higher than in listed stocks. But the reality is the opposite. This is good news for those who invest in listed stocks. If you ain’t cheating you ain’t trying, the sports adage says. Is private equity marketing misleading or simply a lie? Is it ethical? What do You think? REFERENCES: (1)  According to Lerner et al. (2023), the median public market equivalent was 1.0 based on the study of a data set from State Street’s custodial division of real-world client returns across 70,000 investments from 1980 to 2019. See table 2 in https://lnkd.in/dm6vRipz Real-world returns are preferable to theoretical returns based on data bases. Nobel prize winner Eugene Fama says that “[t]he problem is, you can’t measure the returns to private equity because they’re all self-reported. You don’t get to see the bad ones” (see https://lnkd.in/dRzQ6Gp2). This insight is echoed by Brav et al. (2023) who wrote that “we (…) find that [Preqin], one of the most commonly used commercial data bases (…) tends to omit small funds as well as funds with poor performance” (see https://lnkd.in/dQAzDebG ) (2)  https://lnkd.in/dS2Fj2ux (3)  https://lnkd.in/dbCueQWG (4) See chapter on diversification, "the only free lunch in finance", figures 66-67, by Dimson et al. (2022): https://lnkd.in/daiAZaKE #privateequity #privatemarkets #blackstone #ethics #ethicalbusiness #quantitativefinance #quantitativeresearch #misleading #marketingcommunication

THE GREAT VOLATILITY DECEPTION IN PRIVATE EQUITY According to leading private equity players, volatility is much lower in unlisted stocks than in listed stocks (1). However, this is because private equity veils 80 percent of the volatility in a well-functioning market. This article sums up my three previous posts on volatility in private assets (see references 2, 3 and 4). The first article showed how reporting lags create a soothing smoothing effect in private equity returns (2). By plagiarizing the reporting lags seen in private equity funds, the volatility in listed stocks falls by 50%. In the second article, I looked at valuations set by experts – compared to a market (3). The volatility in fair value estimates by Wall Street analysts is about half the volatility in stock prices. The focus in the third article was on asymmetric performance fees and their absorbing effect on volatility. The higher the performance fee, the lower the volatility. Performance fees in a basket of hedge funds have been shown to amount to 50% of the profits above the hurdle rate. Simple calculations tell us that about ¼ of the volatility in funds is removed if performance fees are as high as 50%. If we add the three sources of volatility deceptors together, we can argue that it is possible to take away 80 percent of the volatility observed in a market: VOLATILITY DAMPENING DECEPTORS (1) REPORTING LAGS: 50% (2) APPRAISAL VALUES: 50% (3) ASYMMETRIC FEES: 25% => VOLATILITY REDUCTION: 81,25%* *(0.5x0.5x0.75=0.1875) Despite the fact that market volatility has nothing to do with volatility in private assets, the private equity industry equals low private assets volatility with low risk. According to Blackstone, risk is about half in private equity compared to risk in global stocks, private credit risk is lower risk than investment grade bonds, see figure. I guess there are two reasons why market volatility is mixed with private assets volatility. The first reason is incompetence, the other is intent. Benevolence (good intent) and competence – in addition to integrity and honesty – are often seen as sources of trust (5). Does this raise the question if the marketing of private assets is building or eroding trust in finance? What do You think? REFERENCES: (1) https://lnkd.in/dS2Fj2ux (2) https://lnkd.in/drkXXBKj (3) https://lnkd.in/du3rcgyQ (4) https://lnkd.in/dK77FimB (5) https://lnkd.in/d7Dzyvtk #privateequity #blackstone #ethics #ethicalbusiness #businesspractices #securitiesandexchangecommission #trust

FABRICATION OF LOW VOLATILITY IN PRIVATE EQUITY: ASYMMETRIC FEES According to leading private equity managers, volatility is much lower in unlisted assets than in listed assets (1). We shall see that asymmetric performance fees are a source of the low observed volatility in private equity. Asymmetric fees lower the standard deviation in observed returns. Many people do not find this intuitive. Therefore, I created an Excel sheet for you to simulate volatility in returns after performance fees (2). I put in an 8% hurdle rate and used annual S&P 500 returns data, 1928 to 2023, from Aswath Damodaran (3) to set the mean and standard deviation in returns at 12% and 20% respectively. The figure shows that as performance fees increase, the observed volatility after fees falls. 20% performance fee is conventional, which means the funds keep ⅕ of the returns above the hurdle rate. However, and most importantly, as Itzhak (Zahi) Ben-David et al. (2020) illustrated, a 20% performance fee will in practice translate into a much higher fee. “This asymmetric contract creates severe distortions (...) [W]e analyze the performance of (...) nearly 6,000 hedge funds from 1995 to 2016. (...) [T]he average incentive fee is 19 percent, yet (...) hedge fund managers collected nearly 50 percent of the profits made by investors above the hurdle rate” (4). Let me attempt a short explanation: A basket of funds may not beat the hurdle rate on aggregate, but you will still pay performance fees for the funds that did. Likewise, even if a fund did not beat the hurdle rate over its lifetime, clients may had to pay performance fees in the fund's first years. The attached Excel sheet calculates that 20% performance fees reduce volatility after fees by ca. 11 percent. If we use the actual performance fee ratio observed in the hedge funds industry, where the managers kept ½ of excess returns, volatility after fees drops by ca. 27%. See figure. Lower volatility translates directly into lower beta. When Korteweg (2022) reviewed the literature on private equity beta, he found that academics use a substantially lower beta after fees than before fees (5). On average, academics assume a beta of 2 before fees in buyout and 1.3 after fees, a drop of 35%, close to the 27% above. Leading private equity managers market drop in volatility due to very high performance fees as risk reduction. What do You think? REFERENCES: (1)  https://lnkd.in/dum2gkRj (2)  https://lnkd.in/da5Dsi8d (3) https://lnkd.in/dnGqEUNP (4)  https://lnkd.in/d925hpvE (5) See fig. 1: https://lnkd.in/d5KcHtiA #privateequity #blackstone #ethics #ethicalbusiness #misleading

FABRICATION OF LOW VOLATILITY IN PRIVATE EQUITY: EXPERT VS MARKET Values in private assets are not set by a market. This fact has huge implications for perceived volatility in private equity. We shall see that the volatility of value estimates in private equity can be much lower than market prices. In a previous post (1), I illustrated that the volatility of private equity is low due to a math trick. Because private equity funds report with varying lags, investors will perceive the observed volatility of a basket of private equity funds as very low. This is soothing smoothing for the ignorant. However, additional smoothing comes from private equity values being set by “experts” instead of by market. While the market is a well-functioning mechanism which we know very well, appraisal values are a bit more difficult to study in real-time. Still, we can make an attempt to illustrate appraisal values against market values. The chart shows monthly values of the S&P 500. The black line reflects the observed market prices of the S&P 500 index, the grey line reflects the fair value of the index set by hundreds of equity analysts who estimate the value of each of the 500 companies in the index, and the blue line is a lagged version of the grey line; fair value estimates are lagged according to the pattern outlined in my previous post (1). We see that S&P 500 market prices are much more volatile than fair value estimates from Wall Street analysts. The annualized standard deviation in monthly S&P prices has been 15% since 2005, while the volatility in S&P fair value estimates has been 8%. Introducing reporting lags takes this volatility down to 5%. In other words, volatility drops about 50% when we go from market prices (black line) to appraisal values (grey line). If we combine the reporting lag method with the appraisal values, we observe a further, substantial drop in volatility (blue line). To sum up:   Volatility in S&P 500 (market prices) ===> 15% Volatility in S&P 500 (fair value set by Wall Street analysts) ===> 8% Volatility in S&P 500 (fair value set by Wall Street analysts, lagged) ===> 5%   These illustrations show that the reporting method (lagged values across funds) and the value appraisal method – both in isolation and in combination – give the impression of low volatility in private assets like private equity. We removed ⅔ of the market volatility by reporting choice and valuation design. "The volatility in private equity is very low", said the naïve observer. But the low volatility was a combination of math tricks and appraisal values. The resulting low reported volatility in private assets is marketed as low risk by the world’s biggest private asset managers. Is this an ethical practice? What do You think? REFERENCES: (1) https://lnkd.in/drkXXBKj #privateequity #blackstone #ethicalbusiness #ethics #misleading #valuation #wallstreet #equityresearch

FABRICATION OF SOOTHING SMOOTHING IN PRIVATE EQUITY RETURNS Leading private equity managers claim that volatility in private equity is much lower than in public, listed stocks (1). However, leverage increases risk and most academics assume that beta is about 2 in private equity (2). This raises the question if private markets managers' claim of lower volatility and risk in private equity is misleading. CEM Benchmarking tracks the returns of more than 500 clients across the world who have $15 trillion in assets and they have documented a significant lag between the reported values in private equity funds and market prices, see exhibit ES4 on distribution of reporting lag in their 2023 report (3). CEM Benchmarking finds that 5% of the private equity funds are released with a 0-1 month lag, 8% with a 1-2 months lag etc., see table below for reporting lags across funds:   MONTHS LAG ===> SHARE OF FUNDS 0-1 ===> 5% 1-2 ===> 8% 2-3 ===> 11% 3-4 ===> 30% 4-5 ===> 16% 5-6 ===> 8% 6-7 ===> 5% 7-8 ===> 4% 8-9 ===> 3% 9-10 ===> 5% 10-11===> 1% 11-12 ===> 3%   If we use these reporting lag data to make an illiquid version (with reporting lags) of the S&P 500, we can isolate and study the effect of reporting lag on volatility. The figure reflects the simple arithmetic of lagged returns and the resulting smoothing effect. Based on monthly S&P 500 returns data from 1871, annualized volatility drops from 14% to 7%. Quarterly data gives a volatility drop from 17% to 11%. In other words, by lagging returns we can fabricate a volatility which is half of the volatility in listed stocks. However, this drop in volatility is a math trick. See Excel sheet for calculations (4). Soothing smoothing in private equity may make you feel comfortable, but the perception of safety is due to ignorance. The British economist John Maynard Keynes wrote the following in 1938 (the quote is about real estate but applies to all illiquid assets): “Some Bursars will buy without a tremor unquoted and unmarketable investments in real estate which, if they had a selling quotation for immediate cash available at each Audit, would turn their hair grey. The fact that you do not [know] how much its ready money quotation fluctuates does not, as is commonly supposed, make an investment a safe one” (5) Who is right – Keynes or the private equity managers? What do You think?     REFERENCES: (1) https://lnkd.in/dS2Fj2ux (2) See figure 1: https://lnkd.in/d5KcHtiA (3) https://lnkd.in/dqm6VuDK (4) Excel file based on Shiller’s S&P 500 data. See data sheet, columns x to bn: https://lnkd.in/dSKzsJUH (5) https://lnkd.in/dKWxP6zb #privateequity #ethics #ethicalbusiness #blackstone #buyout