In this episode, Chad Reed and Jeff Eckel sit down with Jeff Hooke, senior finance lecturer at the Johns Hopkins Carey School of Business and acclaimed author, to discuss his new book, The Myth of Private Equity, An inside Look at Wall Street’s Transformative Investments. Jeff dives deep into his thesis that certain private equity funds aren’t nearly as successful as they claim to be and that, as a result, many of their investors, including the pension funds of public employees, are subject to more risk than they think—with taxpayers potentially and ultimately on the hook for unexpected underperformance. Jeff also explores a similar dynamic plaguing the ESG investment space. While more financially focused than many other Climate Positive episodes, we chose to focus on this topic as we believe it is of increasing importance to both taxpayers and investors—including anyone with retirement savings—as we all look to put our dollars into investments that are both profitable and climate positive.
In this episode, Chad Reed and Jeff Eckel sit down with Jeff Hooke, senior finance lecturer at the Johns Hopkins Carey School of Business and acclaimed author, to discuss his new book, The Myth of Private Equity, An inside Look at Wall Street’s Transformative Investments.
Jeff dives deep into his thesis that certain private equity funds aren’t nearly as successful as they claim to be and that, as a result, many of their investors, including the pension funds of public employees, are subject to more risk than they think—with taxpayers potentially and ultimately on the hook for unexpected underperformance. Jeff also explores a similar dynamic plaguing the ESG investment space.
While more financially focused than many other Climate Positive episodes, we chose to focus on this topic as we believe it is of increasing importance to both taxpayers and investors—including anyone with retirement savings—as we all look to put our dollars into investments that are both profitable and climate positive.
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Episode recorded: February 7, 2022
Email your feedback to Chad, Gil, and Hilary at climatepositive@hannonarmstrong.comor tweet them to @ClimatePosiPod.
Jeff Hooke: You're basically seeing a diversion of money from the average Joe six-pack taxpayer on the average state employee into the pockets of these Wall Street titans. It contributes in a way to income equality, but it's also an injustice. It's unfair.
Chad Reed: Welcome to Climate Positive, a podcast produced by Hannon Armstrong, a leading investor in climate solutions. I'm Chad Reed.
Hilary Langer: I’m Hilary Langer.
Gil Jenkins: I’m Gil Jenkins.
Chad: In this series, we host candid conversations with the leaders, innovators, and changemakers driving our climate positive future.
In this episode, Chad Reed and Jeff Eckel sit down with Jeff Hooke, senior finance lecturer at the Johns Hopkins Carey School of Business and acclaimed author, to discuss his new book, “The Myth of Private Equity, An inside Look at Wall Street’s Transformative Investments.”
Jeff dives deep into his thesis that certain private equity funds aren’t nearly as successful as they claim to be and that, as a result, many of their investors, including the pension funds of public employees, are subject to more risk than they think—with taxpayers potentially and ultimately on the hook for unexpected underperformance. Jeff also explores a similar dynamic plaguing the ESG investment space.
While more financially focused than many other Climate Positive episodes, we chose to focus on this topic as we believe it is of increasing importance to both taxpayers and investors—including anyone with retirement savings—as we all look to put our dollars into investments that are both profitable and climate positive.
Chad: Jeff, thanks for joining us here at Climate Positive.
Jeff Hooke: My pleasure. I'm glad to be here.
Chad: We always like to start with a dive into our guest's individual journeys, often both personal and professional. Throughout your career, you weave back and forth between some quasi-public financial institutions. For example, you were a principal investment officer at the World Bank early in your career, and then you've moved into private equity and investment banking, and now, most recently, to academia, where you're now a senior finance lecturer at the Johns Hopkins Carey School of Business and the author of five books, one of which we'll focus on today.
Could you walk us through, a little bit, your career trajectory and what attracted you to each of these different spaces, and how your learnings from a previous role maybe informed your next role?
Jeff Hooke: My career started in New York City. I was in private investments and then I was in investment banking for about 15 years. I had always had a strong interest in public policy. I was actually president of a political club in Manhattan for several years. My international interests also stem from my family background, having a mother that was from Europe.
I'd always had a strong interest in public policy. After my 15 years on Wall Street, I joined the World Bank. I wanted to get into international development. From a financial point of view, I thought someone with a Wall Street background could add a lot to what the World Bank was doing. I spent five or six years there.
The World Bank is not exactly the most taxing job after you've been on Wall Street. A friend of mine said, "Well, maybe you should try something a little extra." That's when I wrote my first book. I had been teaching at Georgetown at night. I thought the M&A book that was for the course was inadequate, so that got me into my first book.
Subsequent to my time at the World Bank, I then joined the international private equity firm that specialized in deals both in Latin America and Asia. Did that. I got a little tired of traveling so much, so I shifted back into domestic investment banking. Did write another book or two.
While I was there as an investment banker in Washington, DC, I was teaching at night, ran into a couple of professors. We did a paper or two on the subject matter we're discussing today, private equity. I just started connecting the dots. After spending a lot of time in investment banking and private equity, I decided I'd go into academia full time, which is what I'm doing now. Talking with colleagues, people in the business, really prompted me to write this book.
Chad: There are a lot of purely academic finance professors in various business schools and economic departments in the US and across the globe, but you've had extensive experience as both a practitioner and now as an academic. Is there some perspective that you think that some of these academics are missing out on if they've never spent any time in the private sector as a practitioner?
Jeff Hooke: Absolutely. Even though a lot of them are very knowledgeable about theory and the way things work in a theoretical side of the business, I think what they lack is the practical experience to see how theory interacts with the people actually doing the business. From a point of view of a student, it's important that they have a theory. MBA students, graduate students. Very important that they have theory, but they also need a heavy dose of practitioner because in my own experience coming out of business school is that I was somewhat unprepared for the actual real world. I wish we had had a few more practitioners when I was getting my degrees at Wharton.
Chad: Let's talk about The Myth of Private Equity: An Inside Look at Wall Street's Transformative Investments, which, quite frankly, is a very scathing indictment of the leveraged buyout world and all those who either profit from it or look the other way as pension funds are raided and middle and working-class communities are decimated. You started this a little bit, but why did you write this book, especially now?
Jeff Hooke: First, you're right as characterizing the book, plain and simple, it's an exposé. As I mentioned earlier, having been in the business from a couple of different angles, I was always a little skeptical of the private equity business. It's grown by leaps and bounds the last 15 and 20 years. Having some public policy interest, I've done a couple of pro bono papers for citizen organizations. Finally, I just had it. I just had a hearing about all the hype and exaggeration about their returns and how great private equity was.
The culminating moment was I was reading another one of these op-eds in the Washington Post saying that private equity again was the best thing since sliced bread. I just raised my hand and volunteered to write an exposé. It wasn't easy. It was a little hard to get a publisher, but I think the theme of the book is going to resonate.
Chad: Tell us a little bit what is private equity for all our listeners who may not be well versed in the subject, especially the difference between leveraged buyouts, growth stage, early-stage venture capital. Can you walk us through the different parts of the business?
Jeff Hooke: Private equity is a different asset class. Fundamentally speaking, large institutions such as pension funds, nonprofit foundations, university endowments, they used to put all their money in blue-chip stocks and bonds, Exxon, Amazon, US government bonds, so on. 15 or 20 years ago, the notion got widely accepted that they had to do better. One of the alternatives or options they chose was to invest in private companies through these large pools of capital called private equity funds.
The idea is that you, as an institution, put your money in some of these funds. These funds turn around and buy private companies, usually. Occasionally, they buy a publicly-traded company. The idea is they buy the company, hold on to it for a few years, try to fix it up, and then sell it after five or six years of holding it.
The whole theory behind it or the whole objective is that this technique of buying private companies and selling them will provide a greater return than investing in publicly traded stocks like Exxon, or Amazon, or Citibank. The unfortunate thing behind the whole practice is that private equity does not beat the S&P 500 and hasn't done so in the last 15 years.
Now, the book itself, rather than focusing on all kinds of private equity, looks at leveraged buyouts, which is about two-thirds of the business. As you pointed out, there's a couple of other important segments of the business. The one we all hear about is the venture capital business that goes into startups like WeWork, for example, or Snap, or companies like that, that are young, don't have a lot of track record. Venture capital puts money behind them and tries to get these young companies to grow and innovate.
The other part of it, which is a little smaller than venture capital would be called growth capital. That is for companies that are growing, that are doing pretty well. They're a little too small to go the IPO or public market route to raise money, but then, again, they're a little too well-established to do venture capital. They're sort of in the middle between LBOs and venture capital.
Now, LBOs are mature companies, they're already making a lot of money. They've been in business for 20 years or so. The vast majority of LBOs are low-tech. With a low-tech profitable history, the buyout, the company can borrow a lot of money, hence the name leveraged buyout. As I said earlier, the idea is you buy a company, borrowing a lot of money, and then you sell it in a few years.
For those in the audience that maybe watch real estate television shows, it's a little like a flipper show. You buy a company, borrow a lot of money, try to fix it up, and then flip it. It's just like one of those real estate shows except, of course, the numbers are a lot bigger. It's slightly more complicated.
Chad: Yes, that's a great analogy. When you were on the private equity side and for the research of your book, what is the pitch that private equity funds use to attract institutional investors?
Jeff Hooke: There's two sides to the marketing pitch, so basically two pillars to it. The number one pillar is, we outperform the public markets. As I said earlier, that happens to be false but it's a good sales pitch. The second pillar is that we are more conservative than the public markets. What does that mean in finance speak? That means our investments fluctuate less in price. They're less volatile than the stock market.
Of course, that assertion is absurd. If you have more debt on your investments, be they real estate or corporate stocks, your values should actually fluctuate more, because more debt suggests more volatility and more bankruptcies. For the last 20 years, the buyout business has gotten away with saying not only do we provide higher returns, we offer less risk, which is something that you would only see in a fantasy. It can't be true. It defies economic logic and financial theory as postulated for the last 60 years.
Chad: You gave a great analogy, I believe, in the book or the presentation that I've seen you on about a mortgage, and how the volatility issue is exemplified there that with greater debt, you have greater fluctuation in equity values. Could you give that analogy for our listeners?
Jeff Hooke: Absolutely. Okay, so let's take the case where you're buying a house for $500,000. Now, of course, a lot of us will buy a house and put 20% down, so let's say you put down $100,000 of equity and you've got $400,000 as a debt. If the house were to increase in value by $100,000 in one year, which actually happened last year, your return on your equity investment of $100,000 would be 100% because the value has gone up to $600,000. If you had paid off all the loans, you'd have 200,000 leftover, which suggest an increase in return of 100%, which is fantastic.
Now, if you were more conservative, let's say you were a grandfather and a grandmother and you had a fixed income, you might buy that house with 100% equity. You put in $500,000, have no debt. The house increases in value by $100,000, so then you have a 20% return and that's $100,000 divided by $500,000. You can see with the leverage option, you've got a return of 100% when times are good, and with full equity, you only have a return of 20%, but let's flip that scenario to the negative.
Let's say the house drops in value by $100,000 which has happened in the past. It happened 10 years ago, how probably selling prices dropped like that. Then you've lost value from $500,000 to $400,000. If you had invested only a 20% down payment, you've been wiped out, your equity is now worth zero. Of course, that happened to a lot of people 10, 12 years ago.
If, on the other hand, you put in all equity, bought the house for $500,000 in cash, you've had a loss of 20%. In the leverage case, you had a loss of 100%, you were wiped out. In the other case, you've had a loss of 20% so you're still surviving. You see the same thing in the leveraged buyout business, where the returns are magnified up and down, and because of their high leverage, about 3 out of 10 buyouts go bankrupt. Isn't far from a less risky business.
Chad: They're able to use certain market-to-market accounting methods to shield this actually greater level of volatility of the leverage buyout funds. Could you talk to us a little bit about how that works?
Jeff Hooke: Precisely. A lot of these investments that these funds are doing, not only in buyouts but the other forms of private equity mentioned, a lot of these investments have not been sold. When you look at a typical private equity fund that says we're making 20% a year, you have to remember that most of their investments have not been sold. The investments are sitting on a shelf in inventory waiting to be sold.
Now, why aren't they being sold? Well, my personal belief is a lot of them are not worth what the managers say they're worth. Since the investments are not sold, someone has to value them and tell people what they're worth. The private equity managers pretty much decide that on their own with some light supervision from their accounting firm. It's a little bit like a college student grading her own term paper. Here, you have gigantic private equity funds saying what their returns are by stipulating what their own asset values are.
It's kind of an upside-down world, but it's been maintained for the last 15 or 20 years with little at all protests from either the institutions or from their government regulators. That's called smoothing. When you manipulate the values to make returns look very smooth and perhaps higher than they should be.
Chad: That's one strategy PE firms use to artificially mask their volatility or juice their returns. Can you talk about maybe a couple of the others, whether that's selling good deals first and quick dividends or credit lines – strategies that PE firms use to artificially juice their returns?
Jeff Hooke: We're getting a little technical, which I don't mind, but just for the sake of the audience, I'll tell them one of the key measurements is the internal rate of return. We probably have some finance people in the audience besides those that are interested in ESG investments.
The internal rate of return is one of the key measurements that the buyout business uses and they say, "Well, our internal rate of return is higher than the stock market's internal rate of return." However, the internal rate of return can be manipulated by a fund. As you pointed out, one of the typical manipulation ways is you sell a good deal first and the dog, you wait until six or seven years later before you sell it. The funds have a 10 or 12-year life, so if you sell the good stuff first and the bad stuff later, the way the math works is your IRR is artificially inflated.
The other thing is what's called a credit line. Some of these funds have gotten so huge. Some of them manage tens of billions of dollars. Funds can buy companies on their own. They can borrow money on their own credit. They buy a company, leverage it up, and then they hold onto it for six or seven months, and then they drop the company into one of their funds.
Now, you might say, "So what's the big deal?" Well, by shortening the holding period of the fund itself, you're going to inflate the return to the fund. So far, no protests from the investors, no protest from investment consultants, and no protest from government regulators. As I said earlier, it's quite amazing.
Chad: I think maybe one of the reason we all should care about this is because a number of large institutional investors, especially the pension funds of various state employees, teachers, other folks, are significantly invested in these funds that are engaged in these practices. Tell us about the fee structure associated with these funds. In addition to the potential less impressive returns than are being advertised, there's a fee structure associated with this that robs these institutional investors of significant capital.
Jeff Hooke: That's a good intro. Why do we care? Why do we people listening care? Well, most of us probably aren't state employees that are relying on our pensions when we get old, so you might say, "Well, why do I care?" But most of us are taxpayers. The taxpayer has to put money into these funds as do these state employees. We're both in the same boat of contributing to these funds. That's why it's important both for taxpayers and for state employees.
Now, as you indicated, state pension plans along with university endowments and foundations, they're the big customers of private equity funds. They've jumped into the swimming pool with both feet, they drank the Kool-Aid, and they're running up huge payments, huge fees to these Wall Street firms for the privilege of investing in private equity, and the fees are in the tens of billions.
You're basically seeing a diversion of money from the average Joe six-pack taxpayer on the average state employee into the pockets of these Wall Street titans. It contributes in a way to income equality, but it's also an injustice. It's unfair.
Jeff Eckel: Jeff, by my calculations, you and I have known each other for about 30 years when I was running around trying to develop power projects in Latin America and you were at IFC or the World Bank. I've always found you refreshingly analytical and refreshingly blunt about some good ideas. You've done some consulting for us over the years when I had some really good ideas that you showed me weren't really all that good. I've really come to respect you. I've read all your books.
What intrigued me so much about this book is the analogy we see in ESG. ESG is by far the biggest recipient of capital in the investing, particularly the equity investing industry. We are an ESG firm, we believe in ESG, but much of ESG is utterly sophisticated greenwashing. There is virtually no focus on climate change in the E, the environmental aspect of ESG. That's the area where we get most passionate about and most analytical. We have our CarbonCount metric to measure the efficiency with which we're reducing carbon with our capital.
I see some analogies of your private equity story, where you can tell a story over and over about your returns and your lower risk, and that doesn't make it true. We see the same thing with ESG. There's certainly a bubble in ESG. I think you've identified a bubble in private equity that I wonder how you see it unwinding.
Jeff Hooke: I'm interested in ESG. I wrote some papers about ESG. It's an area of which the private equity business is increasingly drawn because as you pointed out, Jeff, there's a lot of investor interest, both among individuals and institutions. What you're seeing in the ESG now is very similar, it's almost parallel to some of the problems you see in the broader private equity business, and that is the inability for the industry to coalesce around a standard performance measurement.
In the case of private equity as we discussed a few minutes ago, you have various ways to measure, manipulate an IRR. There's a couple other measurements which can be shaded a little bit in the private equity industry's favor. In the private equity industry, they're crying out for some kind of standard objective measurement that everybody can use and that cannot be challenged or pushed around by the industry itself.
As I see it, the ESG business also has the same challenge. You have various ways that ESG performance can be measured. There's three or four, I guess you'd call them gatekeepers or data services that provide the ESG measurement as to whether a company or a bond is ESG compliant. Eventually, there's going to have to be some standardization.
Now, what you're going to see is pushback from a lot of the players who think, "Well, if there's a standardized measurement, I'll never be cutting the mustard." That's true. A lot of people might fall out if the investment is going to be standardized, but from those investors that really care about ESG and pushing it forward, they're going to have to realize that's a necessity.
Jeff Eckel: When the Green Bond Principles were created, our director, Mike Eckert, who's been on this podcast was at Citi and was one of the followers of the Green Bond Principles. I was pushing him to add a carbon metric and he said, "Jeff, there's just no way Citi will let me do the Green Bond Principles given that 99.99% of Citi's bonds are brown bonds. Someday we'll get there on carbon, but we're not there yet," and this was 10 years ago.
Jeff Hooke: Of course, with ESG, it's not just carbon, there are so many other variables. There's carbon, there's gambling, there's armaments, there's tobacco, there's human rights. There are so many things that can be thrown into the performance mix that it just cries out for some objective standard.
Chad: You've painted a really dark picture of the private equity world and the lack of regulation and the lower returns and fees that various pension funds are paying, and the notion that taxpayers will be on the hook for compensating for some of this poor performance in the years to come. What can we do? What can and should the SEC do to step in and address this problem?
Jeff Hooke: A lot of people, they read the book, they hear me on podcasts or TV, or what have you say, "Oh, you're anti-private equity." That's not true. I'm not anti-private equity. I think there's a need for that kind of investment class. I'm just saying that the fees are too high. The vast majority of PE firms should not be in the business. They should be run out of the business because they're really not performing as well.
That is something that PE industry may face in 5 or 10 years when the returns get more shown into the spotlight. What's the cure for it? Well, the cure is for the SEC or some other government authority be able to legislature or what have you to force sunlight in this business. Basically, just like I was mentioning for the ESG business, they have to have some kind of standardization of fees and returns disclosure, where everyone's using the same numbers and the numbers have to be published in a very straightforward way in a table on page one of your reports instead of buried in footnote 52 on page 169.
That would be the way the industry could be reformed in kind of short order. Now, as far as the big institutions that have been slowly sinking in the PE quick sand from a point of view of fees and returns, I recommend they basically shift their portfolios to indexing. Indexing is a passive type strategy as many of your listeners probably know. The computer selects the stocks and bonds that are publicly traded according to what's in the S&P 500 or the Bond Index.
They're really not looking at what's called active management where they're hiring hedge funds or private real estate funds or these private equity funds to buy and sell assets and try to fix them up because those types of active managers historically do not beat the indexes. It's just a more practical thing to index and try to steer away from the high fee type investments.
Jeff Eckel: Jeff, if institutions index, what will those managers do?
Jeff Hooke: [chuckles] True. I know they all have mortgages to pay. They have kids to send to private schools. They have to take trips to Europe and things like that. They're going to see their income shrink. I think they'll all find something to do besides--
Jeff Eckel: Have you no heart?
Jeff Hooke: This will be a gradual exercise, Jeff. People will gradually pull their horns in a little bit and might take 5 or 10 years if they were to listen to this podcast and follow my advice. It'll be a gradual thing. It's not like they're not going to be employed. I think they'll be employed maybe at a smaller compensation level that reflects both their actual performance and perhaps a lower fee base.
Chad: Jeff, you recently wrote an op-ed in the Washington Post where you tried to bring to light the challenges the Maryland State Pension Fund is having in reaching its obligations, in part, because of the lower actual returns and higher fees that it's paid as a result of its private equity investments. What can the average citizen do to lobby the legislature or otherwise make this issue more prominent, such that regulators at the state level will take action?
Jeff Hooke: Being a Maryland resident and a concerned citizen and I'm a senior fellow at a couple of citizens groups that support the indexing of the public pension fund portfolio. I've been up to Annapolis. I've talked to plenty of politicians about this, and I just think there's a lot of resistance to change the status quo. Many of you think, well, politicians are looking for the best thing to do for their constituents, and for many of them, that's true, but they're also a very conservative bunch concerned about re-election.
They're always hesitant to change things. They're always hesitant to do anything different so when the big pension funds like CalPERS or State of Oregon do something, everybody else just copies them. That happens to be the case in Maryland and most other states, so CalPERS is into private equity and hedge funds, and so the others tend to copy them.
As you can see from that op-ed, the fees that Maryland taxpayers effectively were paying last year were close to $750 million. I think that's a lot of money and the performance as we pointed out was not really any better than a simple 60/40 blended index, so what can the average taxpayer do? It's clear that the politicians don't want to change anything and 750 million, I guess you could say it's not their money, but I think if they were a little more educated, they would do something.
The best thing an average taxpayer can do is send their representatives maybe a copy of the op-ed that appeared in the Washington Post, or--
Jeff Eckel: I've sent them copies of your book.
Jeff Hooke: Maybe call them up on the phone. This is not just a Maryland-type problem, it's basically a problem among almost every state pension fund that's basically loaded up on private equity and hedge funds and some of these other exotic investments, so it's sort of a national type situation that I'm trying to alert people to.
Chad: Excellent. We're almost done, but first, we like to end each interview with the hot seat where we ask you some quick questions, so we'll start with the most important advice I've ever followed is?
Jeff Hooke: When I lost my investment banking job and I decided to go to the World Bank, something different than the private sector. As I mentioned, it was a bit of a slow down for me, having worked on Wall Street. I needed something to fill my time and I asked an older investment banker, "Well, what do I do?" He said, "Well, look to do something productive. Even if you know your job is not 100% of your time, look at doing something productive." He was right. I did go into teaching courses and writing books as a way to supplement my job and I certainly thought that advice was a good one to follow.
Chad: What about the best feedback I ever rejected is?
Jeff Hooke: In some of my books, you tend to get some feedback from editors that I'm glad you follow. In this latest book, I did get a couple of good suggestions about making it a little more connecting the dots a little better from the people that reviewed the book and so I thought that was pretty helpful.
Chad: Success is?
Jeff Hooke: Success is what you make it. A lot of us, when we start off in a professional career, we think it's all going to be linear. I'm going to be working at this job and then I'm going to gradually get promoted, then I'm going to move jobs at a higher salary, and then I'm going to keep going for the next 30 years like that. Unfortunately, for most of it, I don't think it works out quite that way so you have to be prepared to look at success in a couple of different perspectives other than just climbing the corporate ladder.
Chad: The most insightful book or article I've read recently is?
Jeff Hooke: Well, the book I'm currently reading is about the father of Alexander Dumas, the author of The Count of Monte Cristo, which I'm sure many of you've heard about either in book form or in movie form. The father had a rather checkered career as a military officer and some of that book plot was actually derived from the father's career. Some of the people he knew and some of the experiences he had, including being hold up in a castle prison for a couple of years, just like the protagonist in The Count of Monte Cristo.
Chad: If I weren't an acclaimed author and finance professor, I would be?
Jeff Hooke: I would probably be on a beach somewhere in Florida in peaceful retirement, or I'd probably be back in the private sector, closing deals, God knows where, in some foreign country I suppose.
Chad: We're glad you took this route. Then finally, to me, Climate Positive means?
Jeff Hooke: Climate Positive means we're trying to forestall the advent of serious global warming. It's something we have to address globally.
Jeff Eckel: It's going to take a lot of time. Take a lot of money too.
Jeff Hooke: Absolutely.
Chad: Jeff, thank you so much for joining us today. This has been a great conversation, the book is The Myth of Private Equity: An Inside Look at Wall Street's Transformative Investments. Thanks again.
Jeff Hooke: Thanks for having me. Appreciate it.
Chad: Climate Positive is produced by Hannon Armstrong. If you enjoyed this week’s podcast, please leave us a leave a rating and review on Apple and Spotify, which really helps us reach more listeners.
You can also let us know what you thought via Twitter @ClimatePosiPod or email us at climatepositive@hannonarmstrong.com.
I'm Chad Reed.
And this is Climate Positive.