Sampler postings republish pieces previously available only to paid subscribers.
This was originally published on May 31, in the Asset Owner category.
(Watch for an upcoming posting in that category regarding
the goings-on at one public pension plan.)
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A recent Wall Street Journal headline, “Wealthy Investors Pile Into Private Equity to Escape Stock Volatility,” was followed by this paragraph:
Individual investors are increasing their bets on private-equity vehicles, hoping that these funds’ long-term horizon will offer a refuge from volatile public stock and fixed-income markets.
Apparently, investors “are attracted to the premise that private funds can avoid daily price swings and potentially scoop up bargains when markets fall,” since flows from individuals have picked up. Also made clear by the story is that the purveyors of private equity have their sights set on individuals as the source of the industry’s future growth.
A representative of one firm said that demand for private equity would continue to grow, “as more investors reject a traditional 60-40 allocation between stocks and bonds”:
“Bonds have always been the ballast when equities are going down. If they’re not, where do you turn?” he said. Private-fund managers “will be the beneficiaries” of the turmoil in public markets, he said.
Private equity as Ballast 2.0.
The implications for investment advisors from the increasing interest by individuals in alternatives were covered in an earlier posting. This one concerns the beliefs and actions of institutional asset owners in regard to private equity (and, by extension, other private asset classes).
Volatility
The title of another essay from The Investment Ecosystem was “Capital Market Assumptions as Explored Beliefs.” There is a chart within it which illustrates the assumptions about different asset classes from nearly forty well-known consultants and investment firms. For private equity, there are projected “standard deviation assumptions of less than 10% out to 35%. The former must believe that the smoothed numbers reported by general partners represent the true volatility of PE, while the latter scoffs at such an approach.”
A new Verus report on a different private asset category reminds us of the general problem:
Interpreting the stated volatility . . . is tricky. This is because, as with all privately-traded assets, the reported volatility of private assets understates the true risk of those assets, due to appraisal-based pricing and lag effects. Investors do not know the true volatility of assets that are not traded daily on a market exchange.
The enormous spread in forecasted volatility for private equity indicates that the lack of knowledge has translated into a wide range of beliefs among those publishing capital market assumptions — and that is mirrored by those of asset owners. Why does that spread persist?
It is of obvious benefit for the private equity industry to foster the belief that private equity offers lower volatility than public equity (an idea which can be strategically reinforced by a manager through its valuation and smoothing practices). What’s less clear is why others involved in the process, like consultants, OCIOs, and actuaries, would offer low estimates of volatility (or not object to them when offered by others), although a cynic might say that increased complexity in a portfolio generally means increased fees for intermediaries over time.
The other factor: In many cases, the low-volatility message fits with what the customer wants. A generation of allocators has grown up working in and believing in private equity — and many investment committees and boards at leading institutions include private equity professionals. They are effective promoters of the industry’s message.
On the other end of the expertise spectrum it is a different story, with many decision makers essentially holding the “Ballast 2.0” beliefs cited above. The numbers say that private equity has been a way to get higher returns at a low level of volatility; that’s a formula for vocal support rather than for an examination of the risks that may be hidden or the possibilities for disappointment in something other than the benign markets of the last decade.
It’s equity
Among the many reactions to the piece in the WSJ was a tweet from Cliff Asness: “Institutions are stuffed to the gills with expensive equity specially designed not for alpha but to allow them to pretend they don’t own equities.”
Asness is famously cantankerous — and conflicted in a sense, since his firm offers other kinds of investment products — but he hits on some important questions. Are asset owners “stuffed to the gills” with private equity because it has been an easy, if duplicitous, sale? How much of a factor has been the desire “to pretend they don’t own equities”? Are private equity funds really not designed for alpha (but for asset accumulation, driven by that pretension)?
Unpacking those questions in a detailed way would require going well beyond a tweet or a blog posting, since there is a wide spectrum of asset owners, which vary as to asset size, allocation to private equity, history of exposure, and motivations for investing. But there’s one thing that’s obvious.
It’s equity.
In case you’re unsure, recheck the name: private equity. Therefore, pretending it’s not equity is not an option, while being clear about its attributes is an absolute requirement.
Today’s environment
A February report from State Street was issued in the thematic category of “Enhancing Portfolio Diversity.” It included this:
With valuations at high levels, there may be limited further upside for listed equity — particularly as the Federal Reserve is expected to start a rate tightening cycle. Institutional investors may opt to increase their allocations to private equity to help them hit their return targets.
That’s one good example (there are many more) of the rhetoric that is broadcast into the marketplace by investment firms (and echoed by media outlets). While some diversification from public equity is possible with private equity (since the universes of each are different in composition), that’s not what the excerpt above is implying. It’s a simple entreaty to go to the private market if public equities seem like they might be overvalued.
Which brings us to what kind of equity private equity is — especially what kind of equity it is today — since its current nature will set the foundation for the returns to be captured over the coming decades; history may or may not serve as a useful guide.
Dan Rasmussen of Verdad recently wrote a piece called “Private Equity: Still Overrated and Overvalued?” The title referenced his description of private equity from four years ago as being “overrated and overvalued.” He was wrong, or at least very early; the party continued in earnest.
Now he thinks that “future returns look materially worse and future risks materially higher” than they did back then, and offers statistics indicating that the circumstances today are substantially different than the ones that led to the good returns of the past.
From Rasmussen’s conclusion:
The average US buyout transaction looks quantitatively like a highly leveraged micro-cap public equity. In 2000, the average buyout was completed at a 50% discount to the S&P 500; in 2021, the average buyout was completed at a 10% premium to the S&P 500, during a period when S&P 500 valuations soared to near record levels. To justify these prices, PE firms have shifted to growth sectors like tech and healthcare. Leverage levels have increased. Credit stats look significantly worse than B-rated corporate bonds. In sum, PE LPs are paying higher-than-S&P 500 prices for near-distressed credit quality micro-caps with a heavy sector bias toward tech and healthcare.
Perhaps he will be wrong again. But his description of the composition of private equity and its relationship to public equities can be verified elsewhere. Given just the last sentence above, how volatile would you expect a portfolio with that makeup to be in absolute terms and relative to public equity? What is the nature of the return distribution going forward given those valuation characteristics? What kind of correlation with public equity is there likely to be?
Examining beliefs
At a time like this, when markets have been under pressure and talk of regime change is in the air, there’s more than enough to worry about. It is hard to prioritize given all the balls in the air, to say nothing of taking the time to focus intently on something that for most is viewed as settled business, as a long-term commitment to be maintained. But “beliefs about PE” ought to be on today’s research agenda for asset owners and their advisors — and on the upcoming meeting agendas for the investment committees and boards that are responsible for governance.
What could be more important? Private equity has become exceedingly popular and is heavily used by many asset owners. If their expectations for it are off kilter, it could cause major problems down the road.
There are many facets of private equity to consider beyond the capital market assumptions mentioned here, but they serve as a good framing device to start an examination of beliefs. It’s time to clear away the misconceptions and reexamine the expectations for private equity and its role in portfolios for the future.
Published: September 19, 2022
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