E434: Warren Gibbon on How AI is Changing the Private Markets

David Weisburd (0:00)

When you look at these companies plowing in these massive amounts of earnings into infrastructure, specifically data centers, what do you think about that?

Warren Gibbon (0:10)

If you add up hyperscale investment this year, it's around 70% of total corporate US capex.

It's an enormous number, and it's probably going to increase next year, too. What I do wonder is that the beneficiaries of the AI infrastructure spend, chip companies, memory, I'd be careful about underwriting that. There's a massive bifurcation in venture where 12 firms are accounted for about three quarters of the fundraising this year.

David Weisburd (0:34)

You are not bearish on private equity today. Why? Most investors today still believe that the private markets will outperform the public markets. What do you think?

Warren Gibbon (0:44)

I think investors today really need to take a hard look at that thesis.

When I look at private markets, a lot of the data that people focus on is data that is really over the last 20 years, over the last 40 years. One of the biggest things that happened in that period, as we all know, is we had a period of declining interest rates, which acted as a strong, I think, tailwind to returns. More than that, we are looking at a period where equity markets had some volatility. One example I can give you is I have seen quite a few studies looking at the period 2000 to 2020, that 20-year, two-decade period. Obviously, you're really comping off an equity market that was very overvalued in 2000, and then subsequently had pretty poor performance. Today, my number one recommendation for investors and how we're thinking about it here at BFA is, we underwrite what you're thinking as regards private investments, why you think it makes sense today, and really getting back to it to a first principles approach, which is, what are my underlying securities? What are my underlying businesses I'm going to own? Why are they going to increase in value? Because if you're looking at the past and saying, that's what I hope is going to happen, I think that's going to be a disappointing strategy.

David Weisburd (2:04)

What's changed over the last five years?

Warren Gibbon (2:06)

One is a plethora of new players, and the amount of capital that's gone into these markets is obviously very significant. One of the beliefs I have in investing is, large sums of capital coming in is antithetical to go-forward returns. It gets much harder to generate the returns you're hoping for. When you think about the endowment model, which is popularized by Swenson and others, one of the reasons why it was so successful is that they were the first movers in that thesis. You had an inefficient private market, you had lack of sophistication to how you can create value. At the same time, you had some great tools in the toolkit to increase value at companies. You had the benefit of declining rates, which meant you could put more leverage on these businesses.

You had a lot of wind at your back. The amount of capital coming in was also driving returns, I think.

Now, we've got a lot of capital in place, more firms chasing the same amount of deals. And you can see that most clearly in just the multiples, right? We're looking at, let's say, 12 times EBDA for a typical middle market buyout. A few years ago, that was eight. Now, declining corporate tax rates have justified some of that expansion, but it is very tough today. And to underwrite the same kind of returns, you have to make some pretty aggressive assumptions. And that's what we do challenge GPs on today. They're going to be forced to really focus on the operational side, which a lot of them say they do, but I think we need to see more of that.

David Weisburd (3:51)

On the public markets, the multiples have also gone up.

Warren Gibbon (3:54)

Absolutely, David. And I think if you think about what many large investors have, they've really adopted the endowment model.

They've increased their allocation of private markets. And as we've got further into this decade, I think we've seen the fact that one of the corollaries of that is that investors have really underestimated the value generation of the public market. And yes, multiples are high, but the thing I think people are still really struggling to appreciate is the immensely powerful combination it has been for large tech public players to combine revenue growth with very, very strong profit margins and free cash flow generation. Today, that free cash flow has been used to fund the AI infrastructure build out, and we can talk more at length about that. But investors have really underestimated. If you go back, David, to the middle of the last decade, we were coming out of the great financial crisis. We kind of had a jobless recovery. Things didn't feel great. The economy was doing okay, but people were not particularly positive on the equity market. The valuations were somewhat high. It was unclear what the next world driver of Google and Meta were still relatively young companies. The software was having a big change. And this has really been a game changer. And if I think bring it right up to today, S&P earnings in the second quarter are up 29% year over year. Your tech earnings are up 50%.