Allocations to Private Equity are often a significant part of institutional investors overall portfolios. Based on a blend of market price data for listed assets and historical return statistics for private equity funds, standard portfolio optimizing techniques have sometimes been used to motivate hefty allocations to private equity as an asset class. It is a well-known fact, however, that such optimization techniques are very ill-suited for allocation decisions involving private (non-listed) assets as they underestimate idiosyncratic risk and overestimate portfolio diversification. It is more appropriate to view private equity as just another form of equity with somewhat different features.
In this blog post, I will argue that the case for private equity should be a case for active equity investing. Academic research suggests clearly that the average (or median) private equity fund, after fees, doesn’t reward asset owners to a significant degree, considering the risks they load up on in terms of illiquidity, leverage and opaqueness. The only game in (private equity) town is to select and get exposure to the General Partners that in hindsight turns out to be best in class, which obviously cannot be the privilege of all investors.
Private Equity – stylized facts
More recent research on private equity funds, admittedly, suggests that even the average (or median) funds have done better, compared to listed equity, than previous research indicated. An excess return of 3-5 % a year during the PE-fund’s lifetime is suggested in various academic research papers from recent years. Behind those long-term averages there is much time variation, though. More granular studies also suggest that these “excess” returns can be attributed to well-established stylized factors in listed equity markets, such as small-cap, value and illiquidity.
Put in other words, a portfolio loading on such listed equity market factors would historically have boosted returns in a similar way as the median PE-fund turned out to do. Proxys for factors are relatively straightforward when it comes to the usual suspects such as small-cap, value, momentum etc. but illiquidity in listed markets are probably more difficult to replicate in actual portfolios. Nevertheless, beyond replicable factors, the median PE-fund didn’t add much value to investors. Several studies suggest it, in fact, detracted from returns.
Private Equity firms plays a vital role for economic development. Especially when they spot companies and firms that could improve and develop their businesses with the help of operational expertise that PE-firms can provide. Early seed financing and financial renovation could be another tool in such restructurings, even though plain financial gearing can also be a trick for GP´s to boost portfolio returns and carried interest, adding systematic risk to the LP’s portfolio. During a growth– and restructuring phase, non-listing and de-listing of public companies often make sense as it can bring more long-term patience to the management process and reduce the temptation for bosses to steer corporate activity to reaching quarterly or otherwise short-term targets. From an asset owner’s perspective, however, this is always a trade-off. There are strong Corporate Governance benefits from having a company listed and transparent (even though some evidence of the past decade reveals the all-but perfect standard of western corporate governance) while a private company is shrouded in opaqueness. Asset owners should be compensated for, not only the nuisance of not being able to rebalance their portfolios, but also opacity risk.
Superior Due Diligence capabilities and manager access are key
In general, it makes great sense for long-term investors such as Pension Funds, SWF’s, Endowments etc. to consider engaging in PE-ventures. In so doing, they will (and can) offer liquidity and provide longer horizons for corporate planning and development. Asset owners are not automatically compensated financially for such “welfare services”, however. If history is a guide, a fair compensation for illiquidity and idiosyncratic risks associated with PE-investing requires that the asset owner has the ability to select the better performing PE-funds. Asset owners that succeed in this could possibly also be rewarded twice as the excess return generated by the best performing funds should be less correlated with other assets in the portfolio.
Specifically, asset owners must decide if they are possible winners or potential losers in these markets. Rather than focus on generic characteristics embedded in private equity, investors should ask themselves why their due diligence process and manager selection skills should be considered better compared to their peers and/or if they might have better access to the best performing funds than other investors. Because the median (or average) fund is not worth the effort. And why risk ending up in the worst quartile?
Investing in PE-ventures as an LP should thus not be framed as an asset allocation issue but rather a question of manager selection capabilities. Or to put it in more expressive words; while active investing in most listed equity markets is a “side show”, in private equity markets active investment is “The full monty”.