One Young Harvard Grad’s Quixotic Quest to Disrupt Private Equity
Daniel Rasmussen went inside the machine, and didn’t like what he saw.
Daniel Rasmussen makes trouble.
As an undergraduate at Harvard University nine years ago, one of his professors described evolution as common wisdom.
“The only people who don’t believe in Darwinian evolution are evangelicals in the Midwest,” the professor scoffed.
“Is that statement based on fact or anti-Christian bigotry?” Rasmussen asked.
The outraged professor berated Rasmussen and was restrained by a neighboring colleague, who rushed into the classroom to investigate the commotion.
This wasn’t the only professor to face Rasmussen’s blunt questions. Friends say it’s nothing personal. “He likes stirring the pot,” according to Alex Cushman, a squash partner and former colleague.
These days Rasmussen is making trouble for another vaunted community: the private-equity industry, which he claims isn’t generating the returns that pensions, endowments, and sovereign wealth funds assume it will.
Armed with his own empirical research, plus copious studies and data, Rasmussen points out that private-equity returns are trailing public indexes of late. Their results are far more volatile than big investors believe, or the industry itself claims. And, he argues, the ability of firms like KKR & Co., Carlyle Group, and Blackstone Group to overhaul and improve efficiencies at the companies they buy — taken as an article of faith — is largely illusory.
“This is, after all, the leveraged-buyout industry, and not the operational wizard-genius industry,” he says.
Rasmussen, 31, worked at Bain Capital, the elite private-equity firm, for four years. Now he warns that the industry is overpaying for companies. “Public equity is a much better exposure,” he says.
To the chagrin of some, Rasmussen claims he can replicate private-equity-style returns with carefully screened public companies. In 2014, while still a graduate student at Stanford University, he started a hedge fund firm to do just that. Verdad Advisers — though tiny at $80 million and run from his living room overlooking Seattle’s Puget Sound — is posting some head-turning results.
Over the past three years through March, Class A shares of Verdad’s flagship fund returned an annualized 16.3 percent, versus 7.9 percent from the Russell 2000 Value Index. The $40 million fund holds 40 cheap, debt-ridden small-capitalization stocks from around the world.
Rasmussen, following two years of research with colleagues, launched a second iteration of the private-equity replication strategy in 2017, the Verdad Japan Fund. Its Class A shares returned 22.3 percent over the nine months through March, compared to 14.8 percent for the Nikkei 225 Total Return Index.
Walking into the Harvard Club’s wood-paneled dining room in midtown Manhattan, Rasmussen cuts an imposing figure. He is 6-foot-1 and weighs 200 pounds. His dense head of curly auburn hair has been described as a Danish Afro.
He and his two partners — Nick Schmitz, 35, a Rhodes Scholar, ex-Marine, and Verdad’s Washington, D.C.-based portfolio manager, and Brian Chingono, 31, a native Zimbabwean and the Boston-based research director — are all in a good mood as they settle down for coffee and iced tea.
It’s been a successful day of drumming up funds. “We have a lot of investors writing small checks,” Rasmussen says. “We want a diversified investor base.”
Rasmussen’s efforts to disrupt the private-equity business that once nurtured him come as industry giants are facing major headwinds. Returns are lagging, with the Cambridge Associates US Private Equity Index trailing the Russell 2000 over the past one-, three-, and five-year periods through September. Unspent capital committed to private equity hit $962 billion last June, according to PitchBook Data, and the average deal price was 10.6 times cash flow in 2017, versus 7.7 times in 2009, says data provider LCD, a unit of S&P Global Market Intelligence.
None of this augurs well for future returns. Rasmussen has been sounding the alarm in television interviews, at conferences, and in articles, such as the recent American Affairs piece “Private Equity: Overvalued and Overrated?”
“The great postcrisis private-equity gold rush is on, fueled by cheap debt and enthusiastic investors,” he wrote in the February 20 article. “America is in the grips of a speculative frenzy.” The article argues that recent-vintage private-equity funds will likely return close to nothing — and has set Wall Street talking.
Whatever the issues facing private equity, Verdad itself has plenty of challenges. Trafficking in a limited number of small-cap value stocks almost always means serious capacity constraints. “There’s only so much money you can put to work in your best ideas,” says Alex Bryan, Morningstar’s director of passive-strategies research. An asset class like small-cap value stocks is cyclical, adding to the likelihood of sharp drawdowns. And there is potent sector risk, though Rasmussen caps industry exposure at 10 percent of assets. “A lot of the values are in real estate and financial services,” Bryan says.
The number of companies Verdad can invest in is shrinking. From 2010 to 2016 the number of listed North American, European, and Central Asian stocks declined more than 23 percent, according to the World Bank. “His investable universe halved in 20 years,” says Andrea Auerbach, head of global private investment research at Cambridge Associates.
When the market for small, cheap, and leveraged stocks tanks, Verdad runs the risk that investors will flee when able. (The funds have rolling three-year lockup periods.) “The key to earning that return is that investors have to stay in with you,” Auerbach says.
Wearing a blue blazer, green patterned tie, and checked button-down shirt, Rasmussen pours a cup of coffee at the Harvard Club as diners filter into the dimly lit room. Methodically, he acknowledges in turn the various challenges facing Verdad. He expects to close the Verdad Leveraged Company Fund to new investors at $300 million, and the Japan Fund at $200 million.
Verdad and the strategy it is based upon are indeed volatile, a feature of the asset class. “In 2008 our Japan strategy would have had a 32 percent drawdown and the U.S. strategy would have had a 62 percent drawdown,” he says. His job is partly to educate and forewarn investors so they stay the course, as he did in March with a research note detailing the history of steep losses in leveraged equity — and providing data to warn against attempts to market time.
The firm is exceedingly unlikely to ever pose a threat to private equity. “We’re not going to be a large part of the market, ever,” he says. “If the Abu Dhabi Investment Authority wanted to deploy $20 billion, we couldn’t do that.”
Nevertheless, Rasmussen’s growing media profile and incendiary American Affairs article definitely have Wall Street taking notice. “The headline of the article is sensational and tries to scare people away from private-equity investing,” says Mark Yusko, founder of hedge fund investor Morgan Creek Capital Management, in an email. As Yusko sees it, “Public markets (particularly indexes) are far more dangerous today.” Still, Yusko has referenced Rasmussen favorably in his quarterly letters, comparing him to the fighter pilot Maverick in the movie Top Gun.
Others say Rasmussen is only stating publicly what many in the high-fee business say among themselves. “There is a sense that returns are not going to be as robust as they have been in the past,” according to Colin Blaydon, a professor and director emeritus of the Center for Private Equity and Entrepreneurship at Dartmouth College’s Tuck School of Business. Blaydon says Rasmussen’s analysis ignores the pockets of opportunity that may exist for private-equity funds targeting, say, microcaps or sectors like energy.
Rasmussen appreciates the back-and-forth. “What I do is very controversial, so I want to show them how it works,” he says.
Daniel Rapalye Rasmussen makes for an unlikely renegade. Raised amid power and privilege in the Georgetown neighborhood of Washington, D.C., his father, Garret Rasmussen, a prominent antitrust lawyer, was a Harvard classmate of Mitt Romney, the politician and former Bain Capital partner. His mother, Jean, is a homemaker.
All of the Rasmussen siblings excel professionally — “a package deal,” as one family friend calls them. The older brother, William, worked as a journalist before joining Brunswick Group, the high-powered public relations firm. Lisa, Dan’s younger sister, is a portfolio manager at the $2 billion Ewing Marion Kauffman Foundation in Kansas City. Robert, his younger brother, works in private equity.
It was at the elite St. Albans School that Dan Rasmussen first displayed his penchant for challenging the status quo. “He was an intellectual standout,” says Ted Eagles, chairman emeritus of the history department and a mentor to Rasmussen. At the time, classmates were routinely involved in incidents involving alcohol and cheating, he says. The school administration, engaged in a fundraising effort, ignored the incidents or doled out punishments with favoritism.
In a series for the school paper, Rasmussen took the administration to task for failing to enforce the standards it promoted. School administrators pressured the paper not to publish his work. “Maybe it showed an early preference for rules-based systems rather than discretionary judgment,” Rasmussen quips.
Some St. Albans classmates shunned him. In a bathroom stall, graffiti read: “Do you want to kill Dan Rasmussen?” There were two boxes to select from, “Yes” and “No.” Within two years the head of the upper school had resigned. Eagles says he thinks Rasmussen’s series contributed. “There’s no doubt that he has remarkable integrity and he expects it of institutions to which he is loyal,” he says.
From there it was off to Harvard, second varsity lightweight crew, and more run-ins with authority, including with the professor of evolution.
Before his senior year, Rasmussen landed a summer associate post at Bridgewater Associates, the world’s largest hedge fund firm. Its rules-based, quantitative investment style appealed to him.
He worked on models to help predict the movement of the Taiwanese dollar based on trade statistics and economic indicators — good experience for a future fund manager. “I’ve always believed in rules that govern behavior,” says Rasmussen. “That was a seductive idea.” He also took to heart Bridgewater founder Ray Dalio’s relentless efforts to educate investors, often in person and through the firm’s daily economic note, Daily Observations.
Harvard president Drew Gilpin Faust taught Rasmussen in her weekly seminar on the U.S. Civil War, and encouraged him to embark on a book project, building on his senior thesis. The topic was an obscure chapter of pre-Civil War U.S. history — an early 19th century slave rebellion in Louisiana that was the largest of its kind, but largely ignored by historians. With few secondary sources like books or histories to work with, Rasmussen traveled the bayous of Louisiana, collecting financial documents, court transcripts, church records, and newspaper clippings. “I built a database that tracked every slave,” he says.
Rasmussen used Google Maps to assess the time required for the rebellion to spread from plantation to plantation, pulling together a gripping narrative of the doomed insurrection, which led to the deaths of more than 100 slaves.
The result was American Uprising: The Untold Story of America’s Largest Slave Revolt, which received generally positive reviews. “Breathtaking,” wrote historian Henry Louis Gates Jr. in a blurb.
Rasmussen graduated Harvard summa cum laude, winning the school’s top undergraduate award.
He was one of three analysts hired by Bain Capital directly out of college in 2009, the first time the firm had brought in new grads at that level. It was a fraught moment for finance. The mortgage-fueled crisis had triggered the deepest recession in generations. In addition to bankruptcies and government bailouts, doomed leveraged buyouts were groaning under impossible debt loads.
After a brief training period, Bain set Rasmussen to work.
“I loved the people I worked with,” Rasmussen says. “Bain still has that Mitt Romney culture. People are conservative, genteel — I mean that in a positive way.”
During his first year he worked on Bain’s $3 billion buyout of Worldpay, a European payment processor that was part of beleaguered Royal Bank of Scotland Group. Bain was paying eight times the company’s earnings — a crisis-era bargain, thanks to severely depressed cash flows.
Ultimately, after more than £1 billion ($1.4 billion) spent on technology and other outlays, Worldpay generated over seven times Bain’s investment, becoming one of the firm’s most successful buyouts of the decade.
“The deals I worked on seemed to be doing well,” says Rasmussen. “Private equity seemed to work pretty well.”
One fateful assignment changed his view.
In 2012 he was attached to a five-person team led by Andrew Balson, a managing director. The Bain buyout vehicle started in 2006, Fund IX, was not meeting partners’ expectations. Indeed, pro forma numbers showed it returning as little as 1.1 times the money invested. Data showed the fund in the bottom third or fourth quartile by performance compared to rival funds.
Balson’s team, including Rasmussen, worked for four months reviewing 1,700 transactions between 1999 and 2010. These included not only Bain’s deals but also those of its top 20 competitors. Rasmussen built the database, and Balson presented some of the results.
The good news was that Bain had a lot of positive things going for it, according to a copy of the report obtained from a private-equity investor. The firm was picking superior companies, for example. But they were in the wrong industries, either cyclical ones or those experiencing price-multiple contraction, meaning the price at which Bain would exit was lower than expected.
Bain’s investment process was flawed, according to the report. For example, for a prospective target to pass muster, the firm required a projected internal rate of return of 25 percent over the life of the investment. That was a common projected IRR. “The first thing I noticed was this massive dispersion of returns,” Rasmussen says. Bain would generate seven or eight times on some of its investments, but with others, zero, and the number that hit the 25 percent return bogey was infinitesimally small. The upshot was thousands of man-hours wasted modeling investment outcomes because the forecasts were inevitably wrong.
There was another surprise. The single best predictor of future returns had nothing to do with the amount of leverage employed, operational changes, company management, or even the underlying soundness of the business. The driver of superior returns was the price paid by the private-equity firm — companies purchased at a lower ratio of price to earnings before interest, taxes, depreciation, and amortization tended overwhelmingly to outperform.
The cheapest 25 percent of private-equity deals based on price-to-Ebitda accounted for 60 percent of the industry’s profits. Cheap buys made good investments. “With the inexpensive ones, there’s a margin of safety,” Rasmussen says.
The firm’s touted skills for selecting companies, arranging financing, and improving operations proved to be a mirage. Instead the best private-equity deals relied on a simple formula — “small, cheap, and levered,” as Rasmussen puts it. He expected the study to prompt major changes at the firm. “Now that we have the data, how do we change our behavior?” he wondered.
Top management was unconvinced. “The idea that their models were useless or worse than useless was not embraced,” Rasmussen says. “It was extremely controversial.” Management was not going to shift to inexpensive deals exclusively. “They wouldn’t take it to the extreme — just don’t do expensive deals.” And so he was left again to stir the pot, unsuccessfully. “My ideas on size, leverage, and cheapness were never going to be accepted,” he says.
Bain Capital issued a statement to Institutional Investor in response to Rasmussen’s concerns. “Bain Capital has an established track record of delivering superior returns to investors, and our funds have significantly outperformed the public markets. The demonstrated capability to improve the operations and performance of our companies, built over the last 34 years, is a critical part of our strategy and success. Mr. Rasmussen was a junior member of our team during his employment without full insight into our investment process or operational value add.”
Rasmussen had an idea where his insights might be appreciated: the Stanford University Graduate School of Business. Rasmussen had his eye on one accounting professor in particular — Charles Lee, a former research chief at Barclays Global Investors, the big quantitative firm that BlackRock acquired. Lee teaches a course called Alphanomics on the economics and skills behind active management in public-equity markets. Students learn to develop stock screens, assess valuations, and select securities for buying or short-selling. Of Rasmussen, Lee says, “He kind of knew what he wanted to get out of being here.”
Rasmussen and Harvard friend Chingono’s thesis, “Leveraged Small Value Equities,” was informed by what Rasmussen had learned at Bain. If the best-performing private-equity deals were based on the purchase of small, cheap companies, could Rasmussen and Chingono mimic that superior performance by creating portfolios of publicly traded stocks with similar characteristics?
Screening for size and price had been used for decades to capture small-cap and value premiums. Because much of the private-equity outperformance depended on paying down substantial debt, however, the pair would need to find an intelligent way to introduce leverage into the process. Ultimately, they decided on three screens. The first measured how much leverage a company employed. The second measured its track record of paying down debt. And the third gauged improving asset turnover, a way to assess a company’ growth trajectory.
Using a University of Chicago database, Rasmussen and Chingono looked at U.S. stocks between 1965 and 2013. Portfolios of the top 25 stocks as per the five screens returned 25.1 percent annualized during that span. They beat the average stock by a startling 11.7 percentage points.
Rasmussen had found the formula upon which to build a firm. “We propose that value investors have something to learn from the barbarians at the gate,” the pair wrote, “and our research points to the ways in which leverage enhances a small-value strategy.”
“His thesis is that debt is not necessarily a bad thing,” says Lee. “Small companies that are leveraged and can pay back the debt are pretty good bets.”
The Verdad Leveraged Company Fund got off to a rough start, including a drawdown of more than 30 percent amid a plunge in crude oil prices in its first year. Since then the largely quantitative process has been delivering. It begins with a universe of 15,000 equities in developed markets around the world. Every month Verdad’s algorithm finds roughly 500 that appear small, leveraged, and cheap. The 150 most attractive stocks, based on the five characteristics spelled out in the paper, are then culled from the broader group. A risk model removes about 25 for reasons like poor credit quality, the equivalent of being rated C or lower. Heavily shorted stocks are also jettisoned. “The shorts are smart,” says Rasmussen. “There’s something bad about the company, or may be.”
In the final stage of the quantitative process, an algorithm predicts the likelihood that a company will be able to pay down its debt, and those deemed unlikely get cut. The algorithm has a 65 to 70 percent success rate.
At this point Rasmussen and Schmitz start to exercise their fundamental skills, combing through annual reports and other filings, looking for information the screens aren’t designed to catch. “We’re looking to eliminate false positives,” says Rasmussen. “The cash may be a one-time event. It looks good but the CEO just got put in jail.” They write old-fashioned six- to eight-page research reports for each of the 40 names, providing both their quantitative and fundamental insights. Ultimately, each quarter Verdad typically trades out five names and adds five.
“We’re looking for reasons to say no,” says Rasmussen. “We’re not optimists.”
Verdad is always looking for ways to build on its initial research. In 2015 the firm began back-testing its screens on Japanese equities. Historically, Japanese small-cap stocks have had little correlation with the S&P 500, making them attractive for diversification. Debt is virtually free in Japan, given government interest-rate policies, and both the government and banks discourage bankruptcy.
Rasmussen launched the Japan Fund in June 2017, and the result has been far less downside volatility compared to its older, global sibling. The fund returned 17.2 percent over the last half of 2017.
Back-testing now is underway on European stocks, according to the founder.
The promising start for Verdad’s funds raises the question of what Rasmussen will do when their success is validated. Nobody seems to think small-cap stock management is his ultimate goal. “He’s going to have a very interesting career and life in which his success in investing is just a facet,” says Terry Considine, a real estate executive and an investor in both Verdad funds. “He has an opportunity that’s much broader.”
Rasmussen says he expects to remain focused on Verdad. “I don’t have a next career plan. I love what I do.”
Whatever unfolds, Rasmussen won’t follow the well-trodden path, say friends like Alex Cushman. “He embodies that kind of character who goes against the grain.”