This interview argues that private equity's high returns come not from improving companies, but from buying small, cheap firms with lots of debt (leverage). Since private equity is now overpriced, Dan Rasmussen says you can replicate its returns by buying small, cheap, highly leveraged public stocks. He especially likes small Japanese leveraged firms because they almost never go bankrupt. He warns that classic frameworks like Porter's Five Forces are dangerous because they boost confidence without improving accuracy.
Dan Rasmussen (Founder of Verdad Advisers, former private equity professional) argues that the core driver of private equity excess returns is not operational improvement, but rather three factors: "size, value, and leverage". He contends that while private markets are currently overvalued, investors can replicate the risk-return profile of private equity by purchasing small, cheap, and highly leveraged companies in public markets.
Rasmussen argues that three core claims widely promoted by the private equity industry lack empirical support.
Rasmussen emphasizes that in private equity, valuation is even more important than in public markets because leverage amplifies the impact of price.
Rasmussen translates his private equity research into a public market strategy: buy small, cheap, highly leveraged companies to simulate the return characteristics of private equity.
Rasmussen believes Japan is the ideal place to execute his strategy because its financial system (main bank system, cross-shareholding among corporations) effectively provides bankruptcy protection for small companies.
Rasmussen systematically critiques Michael Porter’s Five Forces model, arguing it lacks an empirical foundation.
| Position | Guest Sentiment | Key Data |
|---|---|---|
| 3G Capital | Positive (as an exception for operational improvement) | EBITDA margins often double post-acquisition; but uses proprietary capital, external investors cannot participate |
| Vista Equity | Positive (as an exception for operational improvement) | Systematic cost-cutting capabilities in the software sector |
| Japanese Small-Cap Leveraged Companies (General) | Strongly bullish | Only about 1 bankruptcy per year among roughly 3,500 listed companies in Japan; strategy volatility around 17% |
| U.S. Small-Cap Leveraged Companies (General) | Bullish (but cautious on volatility) | Must navigate high-yield bond market panic cycles (roughly every 5 years) |
| Canadian Small-Cap Mining Company (Example) | Negative (as a "false positive" case from quantitative screening) | Trades at 1.2x EBITDA, but carries significant bankruptcy risk |
1. The three drivers of private equity excess returns are size, value, and leverage, not operational improvements. (Rasmussen) — An empirical analysis of 390 transactions shows that post-acquisition revenue and EBITDA growth slow, profit margins remain nearly unchanged, and the only significant change is a doubling of debt levels.
2. Purchase price matters more in private equity than in public markets because leverage exponentially amplifies the impact of price. (Rasmussen) — A higher purchase price not only reduces the denominator (equity value) but also shrinks the numerator (free cash flow) due to increased interest costs, creating a double negative effect on free cash flow yield.
3. Private equity deals priced above 10x EBITDA are generally unlikely to outperform public markets. (Rasmussen) — Based on Cambridge Associates data, historical patterns support this judgment; current market transaction prices have reached 11-12x EBITDA.
4. The direction of leverage matters more than its level—investors must buy companies that are deleveraging. (Rasmussen) — Companies that repaid debt in the past year have a 60% probability of continuing to repay in the following year, a predictability far higher than growth rate forecasts (around 50%).
5. Japan is an ideal market for executing a "small value with leverage" strategy because its financial system effectively eliminates bankruptcy risk for small companies. (Rasmussen) — Among approximately 3,500 listed companies in Japan, only about one goes bankrupt annually, and the strategy's volatility is half that of a comparable U.S. strategy.
6. Porter's Five Forces is a dangerous framework that "increases confidence but not accuracy," leading investors to buy large-cap growth stocks. (Rasmussen) — Empirical evidence from the Chicago School has long shown that industry concentration is unrelated to profit margins; this theory was abandoned by antitrust practice and academia in the 1970s.
7. Investors should use base rates rather than expert judgment for forecasting. (Rasmussen) — Citing Tetlock's research: expertise does not improve forecasting accuracy, only confidence; decisions should be based on historical probability distributions (e.g., "how do LBOs below 7x EBITDA perform?") rather than personal narratives.
8. Most good ideas don't work—experts are often confident purveyors of bad ideas. (Rasmussen) — Financial advisors frequently make equally poor decisions for themselves and their clients; the problem is not malice but the ineffectiveness of the theoretical frameworks they believe in.