Private Equity has been a hot topic to start 2023, which makes perfect sense given the steep drop in prices during 2022 for public markets. This drop brings into question the valuations of privately held companies and more specifically the marks those companies carry in private equity funds (the value that is reported to the investors in such funds in their statements). This is a complex topic divisive more on philosophical rather than ethical or factual grounds. I’ll do the best I can to simplify and explain why we should care.
The topic really heated up with Cliff Asness’s provocative piece in the influential publication Institutional Investor titled “Volatility Laundering”. Cliff has long been a crusader against what he and others in his camp believe to be the absurdity in private equity funds not adequately marking their portfolios to market. Private equity managers, in turn, retort that marking their portfolios to prices of publicly traded stocks that are “artificially” lowered under market duress should not have bearing on the values of their portfolios because they don’t have to sell!
It might help to put an example forward to illustrate the difference…think of company A and company B who are identical in every way except that A trades on the NYSE and B is a privately held company owned by XYZ Private Equity Fund. We’ll say that both of them closed the year 2021 worth $1B. Company A would be worth $1B simply by taking the number of shares outstanding multiplied times the closing stock price – which would be the last transaction as the NYSE closing bell rings. Company B would be worth $1B because that’s what analysts responsible for valuing the fund’s assets say it’s worth (based on book value, future cash flows, etc). Fast forward to the end of 2022 and all of a sudden Company A is worth $800M while company B is still worth (or perhaps after a valuation adjustment, near) $1B. Before casting too many stones at the advantage XYZ company has for its 2022 reporting, think about the inverse and what the case would if the hypothetical applied to 2021 instead of 2022. Company A might have jumped to $1.2B while company B held back closer to around the $1B mark.
That’s just a real loose example and different funds have different processes for valuing portfolios, but it does shine light on the major thrust of the argument. Some argue that the investors in the XYZ fund are done a disservice by their statement values not reflecting the fulness of reality in their underlying investments. They might even say, and would have a decent argument, that they are doing broader society at large a disservice by promoting misallocation of capital with potentially stale asset prices. On the other side of the debate will be those that argue the XYZ fund investors are there for the long term and the fact that animal spirits are driving publicly traded stock prices wildly up and wildly down have no real bearing on them. The fund owns company B and will collect its cash flows along the way and / or sell it when it is ready to do so. The very structure of the fund is set up to avoid selling when it isn’t ready to do so. To this I say that both sides of this debate (far richer than a brief blog post can serve) have valid points. Both can hold pieces of truth in application that when viewed correctly can benefit all investors.
First, I strongly endorse the notion that Private Equity funds should NOT be added to your portfolio for the very reasons they are often pitched to us by the fund sponsors. Sales pitches often come our way that basically all carry the same punch line: “Low correlation with public markets with stronger returns”. The low correlation is solely due to the lack of valuation updates and the stronger returns are essentially now due to extra leverage (so, the extra returns do not hold up as much on a risk adjusted basis). As Cliff points out in his article, this wasn’t really always the case, but as money has flooded PE over past couple of decades the extra returns have likely come down leaving – leverage as the primary driver of extra returns.
Yet, private equity remains a valid option for appropriate (and usually accredited only) investors. I am happy to share the principles we apply for when and where private equity can still make sense. We do this only after arriving at the understanding that there is underlying volatility whether or not we see it and that future returns should be viewed as fairly symmetric on a risk adjusted basis between public and private market investment options. Here are the simple things we are looking for:
*Enter the market through the secondary market for private equity funds (at least for now). This means buying funds at a discount to their reported value, usually because the seller of the private equity fund has a liquidity need and must accept a lowered price to exit. Think of this investment scenario as another form of supplying liquidity, an investment style profitable to the suppliers dating back to Genesis. As markets found distress towards the end of Q3 2022, discounts became increasingly attractive.
*The world has changed in the past two decades with the number of public stocks dwindling and the number of private stocks swelling. According to Pomona Capital, there are now just 4,000 public companies and over six million private ones. In my opinion, this has to be considered in terms of what universe is available to us for which to invest in. Can you be fully diversified among public market stocks only? Probably, for the most part – but likely won’t be a question settled any time soon and (at least in my opinion) worth consideration.
*Part of the Private Equity return can come from value added techniques through specialized skill sets. Some private equity funds can create value by improving marketing, others through better management and others through putting multiple companies together in order to find synergies. Granted, when viewed on an after fee, after leverage, after tax basis the return outlook shouldn’t be all that different from public equities, but it can produce that return from a different risk stream. In other words, its purpose is primarily diversification.
*Perhaps most of all, we are taking advantage of the psychological edge that can come from longer term decision making. This happens by having dollars invested with managers who are focused on beneficial long-term outcomes and by taking away the buying / selling at wrong times that plague all of us human investors. Referring back to Cliff’s article, which is worthy of all the attention it received, he does acknowledge the appeal to the smoother nature (artificial or otherwise) of private equity.
These principles were written with private equity in mind, but many apply to private credit as well. Neither asset class deserves blind allocation for the reasons they are often pitched. But the reasons listed above serve as compelling reasons for a portion of investible dollars in most investors’ portfolios.