Friday, May 20, 2011

Is Private Equity Riskier than Public Equity?

Jonathan Jacob of Forethought Risk, an independent risk advisory firm, sent me a recent blog posting, Private Equity - Riskier than Public Equity?:
Is private equity riskier than public equity?

What if it exhibits lower volatility? Is that lower volatility real or based on some measure of appraisal bias?

My tendency is to believe that there is a measure of appraisal bias which dampens the volatility of private equity - how many business valuation experts would mark down a private equity portfolio by 60% when the broad stock market drops by 50%? Conversely, would they mark up private equity by more than the market's positive performance?

Two heavyweights showdown on this issue - CPP vs OMERS

CPP, on page 28 of their 2011 annual report, demonstrate how they manage portfolio risk with a private equity deal. In order to purchase $100 worth of private equity, CPP sells $130 of public equity then purchases $30 of fixed income and $100 of private equity. In their opinion, the $30 of fixed income is there "to adjust for the higher risk of embedded leverage in a private equity asset".

OMERS disagrees. In their 2010 report OMERS states "the more predictable and sustainable performance of private market assets will underpin total Fund returns during times of depressed returns in the public markets". (p 11)

Personally, I am not a huge subscriber to the efficient market hypothesis - I believe there are opportunities in the markets that can be exploited by those with superior ability in this field. However, I do believe that the idea of private markets as a saviour of pension funds due to its lower exhibited volatility is based on an illusion - that of an appraisal bias in the mark-to-market of those investments. If we valued these assets based on what a 3rd party would pay, that would be more reflective of reality.

I asked a senior pension fund manager to weigh in on this discussion. Here is what he shared with me:

It's cumulative IRR that is the measure that counts. Full stop. Net of currency. Any other measure is misleading or irrelevant.

Also, the only public comp worth anything is a takeover bid that succeeds. If the stock market drops 50 percent, the enterprise value of any specific listed business may well be unchanged.

Have you noticed most takeovers occur at large premiums to the market? Should PE mark to the stock market, and then add a 20 to 50 percent enterprise value premium? That would actually make some sense. The public market bias is hard to shake.

I told him that there is a private market bias too, just look at the LinkedIn IPO. He responded: "LinkedIn is not worth $9 billion, that's the market cap based on the small issue that floated."

I'll tell you from personal experience that nothing pisses off the public market people at pension funds more than the bogus benchmarks and big bonuses that private market investment managers get. One portfolio manager still gets visibly agitated with me when discussing this topic: "It's such bullshit! Would love to see these private market pension managers try to consistently beat the S&P 500. All they do is fly around the world and write big checks to big funds. And they have the gall to call this alpha!?!?"

The private equity pension fund managers respond by stating that public market managers are terrible at beating their benchmarks, so it's best to exploit opportunities in private markets where there is more information asymmetry. Moreover, they claim that the skill set in private equity is in demand and harder to find so they should be paid more than their public market counterparts.

I think pension fund managers should focus on delivering alpha wherever they can find it. Look, my views on private market benchmarks are simply based on economic theory. They should reflect the leverage, beta, and liquidity risk of the underlying portfolio, which is why I prefer a spread over some public market benchmark (even if it's not perfect because of lag adjustments). I also agree with Jonathan's analysis above, the way CPPIB allocates risk between public and private markets reflects these risks (albeit they really complicate things to the nth degree! The KISS principle should apply here too.)

But that senior pension fund manager I quoted above is right. At the end of the day what counts is cumulative IRR net of currency. Everything else is irrelevant. Whether a pension fund invests or co-invests in direct PE investments to save on fees, or through fund investments, at the end of the day cumulative IRR net of currency and fees is what counts!

I have worked in private equity and spoken to a few reputable fund managers. Guys like David Bonderman at Texas Pacific Group (TPG) aren't a dime a dozen (never met him but met other big PE managers). And even he got into some bad deals in the past. I want you to take a close look at the Canada Pension Plan Investment Board's fund partners in private markets. A lot of these funds are the cream of the crop in private markets. Doesn't mean they're infallible, but they have added significant value added over the years and will likely continue to do so. Unlike public markets, there is much stronger evidence of performance persistence in private markets.

Finally, I agree with Jonathan, private markets are not the "saviour" that pension funds make them out to be. Appraisal values smooth volatility and senior pension fund managers often will mark private market assets down in bad years to mark them up when the recovery comes. This helps them collect the big bonus based on 4 year rolling returns. I've seen this so many times that it's become standard practice among the large pension funds.

But I'm also seeing a lot of outright manipulation in public markets. Big hedge funds and big bank prop desks engaging in naked short selling via multi million dollar high-frequency platforms. At one point, pension funds get fed up and say "screw public markets", we're going to move all our assets into private markets and have more control over them. Obviously they can't move everything into private markets and there is a symbiotic relationship between public and private markets, but the shenanigans in our corrupt public markets are part of the impetus behind the institutional shift of assets into private markets.

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