Marc Andreessen’s blog is surprisingly great for non-tech related topics.  Its already raised to the top 10 feed in my feed reader in short couple of months.  Anyways, with the Blackstone IPO all over CNBC this morning, it got me thinking about how LBO funds differ from traditional investments.  I have tons of useless and never applied finance/asset management education . . . so this post by Marc really resonated with me. The most important part is:

What part of the excess return over the S&P 500 index that you are expecting to generate is due to your use of leverage (debt)? Does this indicate that the public companies that you plan to buy are underleveraged? The finance theory of leverage is that a company should take on debt until its cost of that debt is greater than the returns it can generate from that debt — what happens to your model and projected investment returns if public company shareholders and CEOs figure this out and add more debt before you are able to buy them? Further, if what you are really doing is leverage arbitrage versus the S&P 500, why can’t I just buy an S&P 500 index position myself and leverage it up by purchasing call options and get the same result for a fraction of the fees?

Here is the thing, the returns for LBO funds (like Blackstone) looks great compared to the S&P500, but its actually (somewhat of) an illusion.  A large percentage of LBO fund return is from borrowing money to purchase equity which creates an amplified return on a smaller base of actual cash investment.  (think getting a mortgage to buy a house and the price of the house goes up).  Thus you and I can actually mimic blackstone by simply borrowing money to buy the SP500 without having to pay the 30-40% "carry" on the investment profit that LBO funds ask for.  Average joes, regularly borrow money to buy houses,  the same can be done for the index. The only problem is that its (very much unrationally) much much easier to borrow against real estate than it is equity. (that is also why we have a real estate bubble right now).

So the harder question to ask is that what ever fund you buy into (including the Blackstone IPO) are they 30-40% better than what you would get through a simple margin purchase of the index? My guess is that only the top 10% of LBO funds will be worth it (including Blackstone) but most of the other funds are just juicing return by taking on more risk . . which you and I can do pretty easily without paying someone to wear

$3,000 Zegna suit, $400 Turnbull & Asser shirt, $80 Pantherella cashmere socks, $900 A Testoni alligator loafers, $5,000 Omega watch, $500 Gucci cufflinks, and $150 Hermes tie

I love wall street humor