Private Equity - beyond the Hype

GS sees a seismic shift, the markets are crashing, but everybody agrees individual investor will get a bigger share of it.

Hi! It’s George from Investorama.

Thank you for joining me in the exploration of the future of investing - without the hype.

I’ve looked into investing in Art before. I continue to peer into asset classes beyond the hype through the lens of finance and marketing. It’s the turn of Private Equity.

Last week Goldman Sachs (GS) published A 'Seismic' Shift in Private Markets. They have been bullish and vocal about Private Markets for a while, but when I saw the email, I thought at first that seism meant a catastrophic, adverse event. The markets have shifted; the era of excessive liquidity is over; the bull run has ended; the most active players in private market tech like Softbank and Tiger are licking their wounds.

But no, they are still bullish. The seismic shift is a positive one for the industry: the individual investor (finally) getting access to Private Capital.

Last year, the industry grew to $10 trillion — and is projected to hit $18 trillion by 2026.

Individual investors are becoming a larger part of the investor base due to the democratization of alternatives. What we see from some of the very large public alternative investors out there is that they’re expecting to raise 20% to 30% of their next round of funds from the individual investor. That is a huge change from the 5% to 8%” that it had been historically.

The attraction to the asset class is primarily driven by performance: 300bps to 500bps above public equity markets.

GS looks through the industry lens.

To discuss PE beyond the hype, we’re taking the investor side. It requires approaching it with a beginner’s mind and reviewing the main criticism of the industry. As usual, it’s not a theoretical exercise. I’ll share my practice related to private markets at the bottom of the email (NOT INVESTMENT ADVICE).

We can all join the PE party now! Scene from Barbarians at the Gate

The investors’ perspective

To rephrase GS:

PE has outperformed. It was only accessible to institutional investors; now, individuals can access it too.

The pitch flows naturally from here.

You can now invest in an asset class that has outperformed and used to be exclusively for large, sophisticated institutions.

‘You’ mostly means millionaires, although it’s not a strict criterion. Just over 1% of all adults worldwide are millionaires. Not exactly commoners, but it still makes for about 56.1 million people. Individual countries will have different regulations; you may need to be an “accredited investor”, which is not only about net worth. There’s a trend of ‘democratization’ of alternative assets, including PE.

There are now numerous ways for Investors (Limited Partners or LPs) to invest in funds (General Partners or LPs):

New platforms, such as Moonfare, Securitize, or Yield Street, provide easy access but are not the only ones.

Some of the biggest firms, including Blackstone Inc., Blue Owl Capital Inc., Apollo Global Management Inc. and Ares Management Corp. , have created a host of new products aimed at people with $1 million to $5 million in investible assets and are hiring armies of staff to market them to private banks and independent financial advisers.

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There are also popular equity crowdfunding sites like Public, Republic, and Crowdcube, which offer direct access to early-stage companies directly.

There are two parts to the pitch above (performance; access), which gives us four possibilities.

1. PE will outperform AND individual investors’ participation will be high

2. PE will outperform AND individual investors’ participation will be low

3. PE will not outperform AND individual investors’ participation will be low

4. PE will not outperform AND individual investors’ participation will be high

There are two good scenarios: 1 and 3; and two bad ones: 2 and 4, although 4 is much worse.

We could add some nuance:

• As individuals, we are exposed anyway through institutions that invest our pensions or other assets in PE

• Outperformance is not necessarily a great outcome. If the equity markets are -20% and PE does -15%, it’s not great.

• There are different types of PE (which can also include Private Debt), and direct exposure (crowdfunding) is not comparable to funds

• We could also go into the investment horizon, vintage years, fees, stages

Source: UBS, 2020

But, I’ll skip the details to focus on how investors should respond to the pitch.

Finally, we can access the great returns of PE 🥳

Or

We’re in a bearish market; let’s stay away from the PE democratization hype🫣

A first look at PE

If you look at PE with a beginner’s mind:

• It’s private: there’s no liquidity, the time horizon is long. It is described as a positive. Private equity managers tend to have a hands-on approach to running their companies and are better able to manoeuvre corporate initiatives without the short-term pressures that affect listed companies

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  . However, that’s entirely dependent on the skills of the manager.

• It’s equity: a successful exit means entering the public market (IPO) or being bought by another company (for which the share price will matter). As such, it looks very connected and thus correlated to the public markets.

• It’s long-only: you can only buy and hold, compared to a hedge fund that can do long, short, relative value, multi-asset.

• It’s operating in small and medium caps: the investment universe is restricted (At around $44 billion, if successful, Musk's Twitter takeover would be one of the largest in history)

The evolution of PE

Private equity is healthier today, the returns used to be driven by financial engineering and leverage, but that recipe no longer works. You actually have to make what you buy better.

They mention that PE managers can bring resources that the companies couldn’t access individually and synergies between their portfolio companies.

I find this slightly problematic for two reasons:

1. Making them better sounds a lot … nicer than making them leaner. Cost-cutting is a typical value-adding strategy. Is it less of a priority nowadays? Or is it just a way of reframing the narrative?

2. The ability to pool resources makes me think of PE firms as conglomerates. A model that’s typically not super-efficient and normally trades at a discount… unless the management is highly skilled and adds value.

The characteristics of the asset class are not thrilling per se. It doesn’t have to be a deterrent - the hedge fund asset class can do anything in theory, yet it typically disappoints - but it means we need to find the sources of returns somewhere else.

It appears to all come down to skills, but are all managers highly skilled? And why are their skills superior to that of founders or previous owners?

Skills

Taking a candid look at the PE (and VC) skills, I’d group them around the following activities:

1. Buy: finding the right companies (or startups) to buy (or participate in) at the right price

2. Fix: improving (or helping) them

3. Sell: them dearly

Those are some of the skills that LPs could look for in their GPs. Sometimes they can be outsourced: Tiger Global used Bain for the due diligence (1), and Investment Banks play a critical role in the IPO process (3).

They’re also complementary. If you have a knack for finding opportunities, you don’t need to improve them too much. Potential buyers will see their value if you’re great at improving companies. If you’re terrific at marketing them, maybe you don’t need to work so hard on the rest. You should hit the jackpot every time if you have the complete set of skills.

And it looks like some do. Research shows that there’s a massive dispersion in returns. For example, top managers display over 50% annual returns.

Source: McKinsey Global Private Markets Review 2019

So the name of the game could be to identify the managers with the greatest skills. This may prove hard for private investors who must do their due diligence. Some platforms offer to solve this:

Moonfare members pick from our carefully-curated selection of top-tier private equity funds. Each opportunity is methodically-vetted by our investment team, which boasts a combined 85 years of experience in the private equity industry.

Who are the top-tier funds? A quick look at the website displays many of the largest and most well-known funds.

But isn’t Tiger having a terrible time?

The challenge to that approach is that there appears to be no performance consistency.

Closer examination reveals that these estimates are inconsistent over time, cautioning against extrapolation from historical averages.

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If skills drive performance, it looks like it’s hard to maintain it over the long term. A few firms dominate in terms of assets: Apollo Global Management, The Blackstone Group, The Carlyle Group.

But if PE were a sport, it would not be tennis, where the trio Federer-Nadal-Djokovic have won 62 of the last 77 Grand Slams (81%). In PE, you could invest in the winner of Rolland Garros, Nadal, and end up with the performance of Benoit Paire the following season (the French will understand).

(This article goes further into the compendium of research and offers reasons why persistence is so hard to find).

Performance

After witnessing this chart, you’re going to tell me I’m bickering about petty matters such as skills and consistency and stuff.

Private Equity Index (blue) vs S&P 500 Index - Source: Moonfare

It’s so stunning that we must take it all in before continuing.

I’ve written before about illiquid assets and the Art of data manipulation. I have to mention that the chart compares an investable, liquid instrument with a calculation based on IRR, so it’s not apples to apples. But unlike what Masterworks does with art data, here, it’s an independent source and a public methodology.

Let’s review the main criticism:

1. The IRR is misleading

2. The fees are hidden

3. It’s just Beta (it can be replicated)

Each deserves an in-depth explanation. Here, I can only summarize the main conclusion while pointing to the links.

The IRR is misleading (article & research)

The leading voice here is Oxford University Professor Ludovic Phalippou.

• The internal rate of return (IRR) used in the chart above, and the most common measure is not an actual rate of return.

• It overstates returns and can be easily manipulated

• In reality, the overall return of PE matches relevant public equity indices

Phalippou makes a similar case regarding Apollo’s IRR of 39% since its founding in 1990. He argues that this figure is “severely distorted” given the limitations of IRR; to illustrate, he highlights that a $100 million investment in 1990 that truly were to compound at a 39% annual return for 29 years through 2019 would be worth an impossible $2.3 trillion.

The fees are hidden

It is a point made by Phalippou and a few others. 2% management and 20% performance fees are still the standard in the industry (2 and 20), but other fees may be harder to compute for LPs. The SEC is looking into potentially reforming that.

It’s just Beta (article)

I’ll paste the summary from FactorResearch below:

• Private equity return data should be viewed with caution

• Returns are likely overstated, while volatility is understated

• Private equity returns are highly correlated to public equities

But a picture makes it easier to grasp. It’s possible to replicate the Private Index with public stocks.

Source FactorResearch

The main reason to invest in PE is its stellar past performance, yet it could be replicated with a relatively simple methodology?

Final thoughts

I’m writing this on 13 June 2022, and the S&P 500 entered a bear market. The price of Coinbase is now $52. A year ago, its IPO price was $328, netting $7 billion to the firm Andreesen Horowitz (A16z). They recently launched a new record $5.4 Billion crypto fund.

It is not a fund marketed at individuals, and the crypto part makes it very specific, so why am I even mentioning this? I think it’s an excellent example of a very tempting Private Markets proposal (and because it’s purely theoretical, it cannot be investment advice):

• They’ve done it before. They just need one ‘other Coinbase’ to return the fund.

• The markets have crashed. They can go bargain hunting

• It’s for the long term. They appear highly skilled

I’ve been thinking about this and wondered. What would I do IF I was a millionaire and IF A16z had offered me to participate in their crypto fund? I would have been very tempted … then I found out they invested in Adam Neumann’s (of WeWork fame) Goddess Nature Token project, and I decided I’d run away from it.

Overall, this personal research means I would not invest a significant proportion of my assets in PE funds. It’s too complex, dependent on elusive skills, and correlated with overall equity markets. And if I wanted this type of risk, it looks like small caps could be a decent, cheap and liquid proxy.

But this is very theoretical. In practice, I’ve scanned through my portfolio and found that I have some investments in private markets (excluding real estate):

• Tiny participations in various startups via Crowdcube: It’s companies that I like; although I barely pay any attention to the valuation, I am mainly interested in the shareholders’ update

• About 4% in “real assets”, such as real estate, forestry, and infrastructure, mainly via Unit Trusts. They have performed relatively better than the rest, although they are just about flat overall.

PS: There was a typo in the previous newsletter; the crypto market cap should have been $1.2 trillion (i.o billion). PPS: Today, it is $1 trillion.

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I’m planning more “behind the hype”: Crypto, Hedge Funds, NFTs.

But next, I’m going to talk about stablecoins again! Hint: there is no stablecoin market; there are just a few experiments to choose from.

1. https://www.wsj.com/articles/blackstone-other-large-private-equity-firms-turn-attention-to-vast-retail-market-11654603201

2. https://www.preqin.com/insights/research/blogs/private-equity-rewards-consistency

3. https://www.jstor.org/stable/43503754