Profits, Fast and Slow

There's an old joke among diamond dealers about a guy who always sold gems "at cost" yet somehow made a fortune.

"How do you do it?" his friends asked.

"I always buy below cost!" he replied.

Private equity funds use a similar trick. But, sophisticated as they are, they take it a step or two further. Imagine buying something for $100, immediately claiming it's worth $150 simply because you own it, and then... charging your clients a fee for the $50 of profits you generated.

That's essentially what some private equity funds do. According to a recent report in The Wall Street Journal, funds purchase private assets at discounted prices on the secondary market, then immediately mark them up to their official valuation, regardless of whether anyone else would pay that price. "Marking up" simply means updating their value on the fund's balance sheet, perhaps with a note from an accountant that the asset was acquired "under duress" or some other "unusual circumstances" that made it possible to buy it for less than it is worth. As the asset is suddenly worth more than the fund paid for it (on paper), the fund managers make a profit and can charge their own investors for the (unrealized) gains they generated.

Why do investors let this happen?

Because these inflated values make everyone look good. Fund managers collect performance fees based on these unrealized "profits," and investors get to brag about impressive returns, earn a promotion, attract more investors, and improve their reputations.

Everyone lives happily ever after. Until it all crashes in a "Black Swan" event, which no one could have predicted.

Have a great weekend!

P.S. — I am tinkering with a new landing page for my newsletter — OldNew.com What do you think?

Best,

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