How Private Equity Funds Manage Such Big Returns

| About: ProShares Ultra (SSO)

Are you jealous of Blackstone?  Have a hankering to be like KKR?

No problem, dear readers.  We at Running of the Bulls are here to enlighten you on how to make 40% a year, just like the private equity funds, without having to pay the extortionary fees just to have the privilege of participating in a pool of capital in which you are not allowed to withdraw any money until your first born is in college.

First, one must understand how a private equity firm generates such magnificent returns. 

Its easy!  It goes something like this.

  1. Find a publicly traded company that has a ton of cash on its balance sheet, is magnificently free cash flow positive and is being ignored by the stock market.
  2. Offer to buy said company at 30% above the market price.  The stock market - which has the attention span of a hummingbird - will be thrilled.
  3. Once you own it, gut the company of all its cash, paying yourself a ridiculously handsome dividend, using gianormous amounts of debt to pay yourself that dividend.  You deserve it.
  4. Fire half the employees.  
  5. A few years later, when the stock market has finally turned its attention to the industry in which the company you just hallowed out and gutted the balance sheet operates, take the company public at a higher price at which you bought it.  Emphasize the efficiency gains and much higher return on equity of the company that you generously imbued your business acumen upon.
  6. Convince Congress that secretaries and hamburger flippers should be taxed at a higher rate than you.

Voila!  You're a billionaire! 

But since you - the average Joe who didn't go to Harvard and spend the first two years of your post-MBA career photocopying for 120 hours a week deep in the bowels of an investment bank - can't do that, here's a way for you to generate similar returns in a similar manner.

Pleas send me $249 for a copy of my software which will tell you how you can...

Haha! No, just kidding.

Here's how you do it.

  1. Go open a margin account.
  2. Buy one of these ultra floating ETFs which return two times the market rate, such as the ProShares Ultra S&P 500 fund, ticker SSO.  Use maximum leverage.
  3. Sit back, relax and watch the money roll in.

If you are a money manager, stick the money offshore.  Hire a New York valuation firm to tell you what your account should be worth.  Ignore what is happening in the stock market.  Charge your clients high fees.

Satirical commentary aside, much of private equity returns come from increasing the leverage they own.  The PE funds have the luxury of not marking their investment to market, thus are not bound by current market valuation as market movements are often considered transitory.  They also choose when to sell their company back to the public markets.  PE funds are able to exploit this "asset class structure arbitrage" quite profitably.

In our example, if one can stomach the volatility and can put up extra cash for margin calls during downdrafts, over time, one would earn similar returns.  The average return of stocks has historically been 10%.  Buying a double floater ETF increases the historical return to 20%.  Buying the ETF on maximum margin generates average returns of 40% per year.

Of course, even the casual investor can see the inherent dangers of such a strategy.  However, initiating such a position in 1982 and removing it in 1999 would have made one very wealthy.

It goes without saying that it would be enormously stupid to do this now.  Bear markets are not a good time to lever up positions in stocks with everything you have.

But you get the idea.

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