Business Ownership vs. Private Equity vs. Small Cap Fund

[ThisDinosaur]

Conventional wisdom says that fortunes are usually made through business ownership or real estate (which is a form of business). Conventional wisdom also says that most businesses fail in short order.

The implication of these facts is either 1)successful businesses are lottery tickets, and/or 2)entrepreneurs are people who have a high tolerance for multiple failures before winning their inevitable fortune.

Well it turns out there is some research showing that private equity is correlated with public small cap indexes. Which makes sense.

Do you agree?

Have you ever owned or invested in a private business? Or more than one?

Would you say your ROI was at all similar to owning a small cap index fund? (Averaging over all your businesses and accounting for your own labor.)

[suomalainen]

Not sure exactly what you're asking re: agreement, but my $.02:

I work in private equity. I think we target 16-20% returns across the PE portfolio. The benchmark we use to measure performance is something like Russell 2000 + 600bps (or maybe 300?, I forget). Industry-wide (i.e., PE funds) the returns are lower than that benchmark (so maybe ~10%). Size matters (mega funds typically earn less than smaller ones), experience matters (first time funds are a lottery ticket), etc. and industry-wide average returns pick up all those differences.

As to ownership in private businesses, some are home runs and some aren't. We've gotten donuts and we've gotten 4x multiples and 50%+ IRRs and everything in between. Diversification is key.

If you're talking about owning your own individual business, I think 1 AND 2 are applicable. You won't succeed if you aren't a hard worker and willing to overcome failure, but that's not sufficient, you also need a lucky break to make more than just a decent living. Lack of diversification makes 2 challenging psychologically, is my take (without experience because the psychological barrier is too high for me to overcome).

[jacob]

It's perhaps interesting to note that the largest company in the US (Cargill) is private equity. ROE is definitely higher for PE(*) and evil tongues might suggest that IPOs is what happens once IRRs start declining---sell it to the suckers^H^H^H^H^Henthusiastic public. I suppose Cargill is just doing too well for its owners to sell it out to the public. Having a strangehold on the world's food supply is probably about as solid as it gets in terms of business cases.

(*) When I first heard the level of returns that private equity investors get, I almost couldn't believe it .. as in "surely trees can't grow into the sky" ... but this is possible for a while if you start with a very small tree (say private microcaps).

If research shows that small cap correlates with PE, I can't really disagree with reality. Fama&French also showed that the market is inefficient wrt smallcap---also bookvalue---and I suppose other things if they kept looking. If you can stand the volatility and are in it for the really long run (like 50-100 years), smallcap is definitely where it's at. But now we're talking dynastic wealth ... not FIRE portfolios.

[Riggerjack]

My understanding is that the way to get the first business rolling is to set yourself up for failure to begin. When it fails, one should be tired, and wiser, and not broke.

If a successful business is rare, it's got to be because most first time businesses are not set up like this, so instead, we see people open a business with not enough of anything, and try to make it work on sheer sweat.

If you start a business with the intent to make yourself whole, regardless of the business's status, failures only cost you time and energy, until you learn enough to make one work.

Then you have other problems to deal with.

Or, at least that's how I see it. With no entrepreneurship experience.

[7Wannabe5]

I think most very small businesses fail due to the critical differences between profit and cash flow.

https://www.inc.com/entrepreneurs-organ ... rofit.html

There's often a wide field or range before declining profitability at the margin of opportunities overcomes inability to take advantage of opportunities due to limitations on cash flow. Simple example would be an independent house-flipper not being able to find anything worth buying on the market vs. not being able to secure/cover financing for more than 3 concurrent projects while also covering his own living expenses/overhead/etc.

[ThisDinosaur]

The "Do you agree" basically meant;
do you agree that owning a small cap index is equivalent to having cap-weighted investments in many privately owned small businesses?

My narrative for private businesses and public small caps is the same: most fail, but a few are profitable enough to compensate for all the rest. That they underperform for years, and then back load all of their overperformance into one year every decade or so.

Jacob's point about profitable companies staying private could be interpreted as a profitability premium. Which is a separate factor from the size premium and marginally related to the book value premium.

So, how does someone with an ERE sized nest egg get exposure to PE? If its true that the PE market is less efficient, then how does one find the best managers? Is it worth the cost and effort to do so if I've already got 20% of my money in small cap value index funds?

[suomalainen]

So, how does someone with an ERE sized nest egg get exposure to PE? If its true that the PE market is less efficient, then how does one find the best managers? Is it worth the cost and effort to do so if I've already got 20% of my money in small cap value index funds?

You don't. That's what has driven some of the talk about adding "liquid alternatives" to 401k plans. Or I suppose you could try BDCs. Those can sort of be viewed as quasi-PE funds.

Or if you know a PE guy who will let you into a "friends and family" vehicle, you're lucky. But they typically require you to front load your entire commitment (instead of pay as you go) so they're not chasing small dollars when it comes time to fund a deal, but that drastically lowers your IRR. Not sure of the numbers. Without a friends and family vehicle connection, you probably have to be able to invest at least 6 figures or more into any one fund. My experience is with middle market managers, so the smaller funds could be more flexible/desperate, but I dunno, seems unlikely.

Also remember that PE funds are subject to securities laws, so you need to be an "accredited investor" ($250k/yr in income last two years or a million in investable (not house) assets, I think) to invest with them. Another thing that is driving some of the "liquid alts" talk.

[ThisDinosaur]

I'm reading about BDCs, liquid alts, and equity crowdfunding. Thanks @suo for those leads.


I've thought of another way to frame my question.

Four individuals; A, B, C and D.

A is an entrepreneur who starts a small business and hires some people. From business revenue he gives himself a minimalist "living wage" and reinvests the rest in his business.

B is employed by A and is an extreme saver. He is not entrepreneurial but has several friends who are. He carefully researches and invests in startups in several different industries. He spends a minimalist "living wage" and invests the rest.

C is also employed by A. He doesn't know any entrepreneurs, but does save all but a minimalist "living wage" for spending. The rest he invests in small cap index funds.

D is same as C, but invests in BDCs and/or equity crowdfunding.

The question is, do all of these individuals' strategies have the same expected return? If not why not?

[7Wannabe5]

In theory, A should have the highest expected return, because A has all the options available to B, C, and D plus the option of investing in his own business.

[Dream of Freedom]

The small cap and BDC investors are likely to have less leverage available on good terms. They only have the debt to equity of those companies and maybe margin, but margin accounts can make you sell when you don't want to. BDCs are required by law to limit their leverage to 200% and many small caps lower debt by issuing equity. So in short I think that the risk and reward are higher for a and b.

[suomalainen]

A. Expected return for the one business is extremely dependent on variables. What industry is it in? What’s the market background and growth potential? How much market share amd projected growth? And barriers to entry for competitors? Etc etc etc. The outlook for a restaurant is VERY different from a general contractor from an industrial supplier of specialized [products/services] from a retail from a franchisee. The question is just too vague to answer. From a portfolio perspective tho, you also have to look at...whatsitcalled...can’t think now...variability. Think like mean and standard deviation. You have an expected return of 10% with a SD of like 30%. Is that good? Would you want to bear that risk? Volatility. That’s what I was thinking of. No diversification, so the volatility is sky-high with A.

B. Venture capital has the highest expected return (and highest volatility) on a PORTFOLIO basis. Portfolio construction is huge here. If you’re not an expert at this, don’t do it. Professional VC funds will make call it 15 investments, 10 of which result in abject failures, 4 of which are whatever returns like 1x or maybe 2x and 1 of which is a homerun, like 10x+. ALL of those investments were made with the hope that they’d be a homerun, but very few actually are. On a portfolio basis, I think typical VC fund returns are targeted at 35ish%. Could be off. But the risk is huge.

C and D: Returns are what they are. Public information is easy to come by ( as opposed to A and B, where you may have challenges in getting good market return information, or they may be data biases to worry about, etc). These are recommended if you have a full-time job that isn’t investing.

[Lucky C]

Warren Buffett / Berkshire Hathaway consistently beat "the market" by buying both privately owned and publicly traded companies. They had to start small and then scale up to larger companies, and more recently struggle to find good deals and beat the market.

This (sample size of 1) example suggests that Small and Value are more important factors than private vs. public.

As far as small cap funds go, NAESX top holdings are MTN with 15k employees and KEYS with 10k employees. VISVX top holdings are WCG with 9k employees and IEX with 7k employees. Compare that to the top four S&P500 companies with 85-556k employees. So in terms of number of employees, a small cap company is only about 1 order of magnitude smaller than a large cap, but it's 2-4 orders of magnitude larger than starting your own business or investing in a very small business of 1-100 people. Therefore I see a small cap fund as being much closer to a large cap fund than to any small business I could start or invest in.

[7Wannabe5]

This (sample size of 1) example suggests that Small and Value are more important factors than private vs. public.

Maybe this is because not everything that is valuable and profitable is scalable? For instance, a small store that deals in pottery local to a region and is only open 3 days/week might provide it's owner with $30/hr wage and pay one assistant $12/hr wage, but that's it. If the owner of such a store could only earn $20/hr if employed by other, and the overhead is fairly low, then the profit might be quite high.

Kind of the same continuum that makes it ridiculous to pay a dental hygienist every time you need to brush your teeth, but equally ridiculous to manufacture your own cast-iron frying pan from scratch.

[ThisDinosaur]

Small and Value are more important factors than private vs. public.

Maybe this is because not everything that is valuable and profitable is scalable?

This is the crux of the issue. Are Small and Value more important than Private vs. Public?

There is a widely recognized assertion that the way to get rich is to start a business, but among people who start businesses most will just get broke.

IOW:

You have an expected return of 10% with a SD of like 30%.
...
Professional VC funds will make call it 15 investments, 10 of which result in abject failures, 4 of which are whatever returns like 1x or maybe 2x and 1 of which is a homerun, like 10x+. ALL of those investments were made with the hope that they’d be a homerun, but very few actually are. On a portfolio basis, I think typical VC fund returns are targeted at 35ish%.

So starting or investing in a new private business is the "same" as investing in a micro-cap so small it couldn't be publicly traded.

The only difference between A,B,C, and D is 1)the size of the businesses involved and 2) the degree of diversification. Is this assertion true? If not why not?

[ThisDinosaur]

Warren Buffett / Berkshire Hathaway consistently beat "the market" by buying both privately owned and publicly traded companies.

At the risk of derailing my own thread, there is an argument to be made that Warren Buffett's success is mostly luck.
Example of such arguments:

http://www.themoneyillusion.com/its-eve ... tt-thinks/
http://www.themoneyillusion.com/being-there/

even if markets were perfectly efficient, they would look inefficient. That’s because for every 1,000,000 investors you’d expect one guy to outperform the market for 20 consecutive years. The masses would call that lucky guy a genius, even if he was just an average bloke from Nebraska.

I'm not saying I believe this. Just that the evidence I've seen doesn't differentiate between Buffett being brilliant vs. being lucky.

[jacob]

@TD -

See https://en.wikipedia.org/wiki/The_Super ... Doddsville or read the original https://www8.gsb.columbia.edu/rtfiles/c ... tt1984.pdf ... also the market wizards series is good for more examples. It's not hard to refute the Gaussian probabilities if you want to. There exists too many successful investors whereas the random walk odds are beyond astronomically impossible (thousands of sigma).

[ThisDinosaur]

This could easily turn into a pro vs anti EMH thread. I'm convinced that Graham-Dodd-Buffett is right that Value is a Thing. The philosophical axiom is that the future resembles the past. Look at a business' past earnings and extrapolate to the future. Compare price.

But small new businesses have no past to evaluate. So real risk is higher. So why should anyone buy them. Well, because historically it's the best way to get rich. But its ALSO the best way to get poor since most businesses fail.

So, an Individual should diversify, thereby limiting upside gains but ensuring that they do get some upside.

Is this the right way of thinking about this? Do the same size and value premiums that explain public equity returns also explain private business returns? Can I get a piece of the action without being an entrepreneur with job title: "founder."

[suomalainen]

The only difference between A,B,C, and D is 1)the size of the businesses involved and 2) the degree of diversification. Is this assertion true? If not why not?

I dunno. I think the more you try to simplify the question, the harder it becomes to answer. A, B, C and D are all ways to go about investing into small businesses. Expected returns are hard to calculate for smaller businesses, newer businesses, private businesses, etc., but there are people out there (consulting firms is what I'm thinking of) that have access to that kind of market data and could ballpark the expected return for any given business in any given geography in any given industry. If you are very experienced in product X and industry Y, then you could probably ballpark an expected return for a business that produces X in industry Y.

What I was trying to say was that A, B, C and D are apples and oranges and pears and bananas. You can try to compare them, but they are all a little bit different. Do you prefer apples or oranges or pears or bananas? You have to take the "bad" characteristics along with the "good" ones for each option. So, if I had to super simplify, my thoughts would be like this:

1) the expected returns for any particular business in the class of "a small business" are just so variable. That's why there are legions of analysts who analyze small businesses prior to making investments in them. But for a given small business, the method of an investor's exposure to it (via A, B, C or D) is irrelevant. The business itself will have an expected earnings potential and you can back out of that an investor's expected return for any given A, B, C or D method of investment. Part of the confusion, I think, in comparing them is that A, B, C and D tend to give you exposure to DIFFERENT businesses or different TYPES of businesses, so it's not just size, but maturity and market and management and a thousand other things that matter.

2) A, B, C and D describe not only an asset class (loosely defined), but also an investment process: Entrepreneurship vs investing in your friends' businesses (or BEING a professional/expert investor) vs investing in a professional investor are vastly different things in terms of what is required from the investor: skillset and time and maybe capital. Different strokes, different folks.

3) Portfolio construction process: In A, there appears to be zero diversification given how the scenario was set up, so that's a single asset "portfolio". In B, you have to make multiple investments to gain some amount of diversification. In C and D, you make one investment that includes some amount of diversification.

So, attempting to answer the original question -- yes, A, B, C and D would have ballpark-ish similar expected returns (i.e., they are more similar to each other than they are to, say, US government bonds), but they're just so different along other axes, that the question was in my mind too narrow (so maybe this is my biases hijacking your question?), so I was trying to flesh out some of the other considerations. You have to look at the whole bundle of what A and B and C and D offer you and what they require to get it, and compare across all of those dimensions rather than just the single metric of "are the expected returns the same"?

[suomalainen]

Is this the right way of thinking about this? Do the same size and value premiums that explain public equity returns also explain private business returns? Can I get a piece of the action without being an entrepreneur with job title: "founder."

Wrote my other response before seeing this. Private (PE fund) returns come from three things:

1) a PE fund offers "professionalization", so they are able to bring mom-and-pop type businesses onto the next level - they improve management by bringing in experienced CEOs or directors, which improve processes/procedures, cut costs, broaden industry contacts, etc. that all relates to organic growth;
2) PE funds often try to buy a "platform company" at a certain earnings multiple, say 8-10x earnings, and then they will go out and search for smaller competitors at LOWER multiples ("bolt-on acquisitions") to consolidate the industry and increase earnings while buying down their multiple. In this sense, your "size and value premium" thought may be somewhat similar.
3) So what you end up with is a nice return from (a) earnings growth from acquisitions (#2) and professionalization (#1) and (b) multiple expansion (buying low/selling high).

As to you, I think private markets and public markets are different for the retail investor. As you note, the information availability is vastly different. Professional private equity investors get access to a private company's books and records (and often hire accountants to do "quality of earnings" reports on them) so they are able to make investment decisions where there are no public annual reports and such. And they sit down with management and ask whatever questions they want. I don't think that same investment process if available to you (unless you have a giant checkbook). This is the "rich get richer" complaint that is often the driver of liquid alts discussions.

[ThisDinosaur]

A, B, C and D are apples and oranges and pears and bananas.
...
but they're just so different along other axes, that the question was in my mind too narrow (so maybe this is my biases hijacking your question)

I have my own biases here. I'm coming at this as a risk averse W2 guy with no entrepreneurial experience who has been trying to buy FI with mutual funds. That's why I'm framing these questions in terms of CAPM, market anomaly premiums, etc. Its the language I'm familiar with and it may be inadequate. I'm trying to relate this knowledge with the idea that business ownership is the way to get wealth.

So, a PE or VC fund includes more than a selection of non-listed businesses. It also includes accounting, tax, and business experts. This is good to know. I'm sure those experts know many more things about how to evaluate a business than my novice-level "risk" and "value" and "industry correlation" criteria. As an example, lets use @7Wannabe5's Cash Flow suggestion. If PE fund guys use this as a criterion, they can buy into businesses that don't need to go public to get funding for growth. This, as Jacob suggested, disproportionately pushes the lower quality, low cash-flow businesses into the public market. This could account for the higher returns of PE/VC, yes?

Any form of investing is speculating about the future. I'm operating under the assumption that these fund managers use criterion in the form of "businesses with these characteristics tend to be the best investments, historically." If that assumption is correct, then my next question is, what is that list of characteristics and how strong is the evidence that those are useful?