Is Private Equity Riskier than Public Equity?

Via Pension Pulse.

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 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.

Comments

[Astute Investor]

In reality, private equity firms do not actually think in terms of IRR.  Clearly, there are various constituencies that focus on IRR, but that can be short-sighted.  For private equity firms, their goal for any new portfolio company is to realize value in multiples of the initial equity investment and not to target a particular IRR which is really more of an output.  The initial investment goal in general is to triple the value (3.0x) of their equity over the holding period.  However, tripling capital over various holding periods results in very different IRR which is why IRR cannot be used as the sole evaluation metric.

If you assume the average holding period for a private equity investment is approximately five years and the value of the investment triples, this results in an IRR of approximately 25%, or the expected return many associate with private equity.  However, triple your capital over a two-year holding period and the IRR is 73%.  Conversely, generate a 25% IRR over a three-year holding period and the multiple of investment is less than 2.0x, one turn below the stated objective of 3.0x.

[ebworthen]

From the outside this reads like a semi-pornographic novel or a "How to win at craps, blackjack, and roulette":

"CPP vs OMERS"

"adjust for the higher risk of embedded leverage"

"opportunities in the markets that can be exploited "

"exhibited volatility...appraisal bias in the mark-to-market"

"It's cumulative IRR that is the measure that counts...Net of currency."

"outright manipulation"

"naked short selling via multi million dollar high-frequency platforms"

"shenanigans in our corrupt public markets"

Leo, having read a lot of your articles I know that your heart is in the right place.  However, you are sounding like one of the patsies in the casino at the martini bar trying to decide if you should bet the come line and a 30 to 1 double sixes on the craps table or bet black and white with an even odd hedge on the roulette wheel.

The fundamental problem is that the markets are not free, they are not capital markets, they are increasingly manipulated and speculated beyond the control of individuals and pensions.  The markets lack regulation or enforcement of existing regulations; they lack freedom, accountability, consequences, and most importantly tethers to the physical world.

Picking out key terms you say it yourself: whether public or private - "the markets are exploited with leverage, bias, accounting tricks, manipulation, HFT, shenanigans, and corruption."

Getting lost in the terminlogy, the catch-phrases, the slogans and verbology, you become an addicted gambler rather than leaving the casino, the racetrack, and talking about the markets becoming markets again, and that the horses be taken from the track and sent to the farm to grow food or sent to the glue factory.

Otherwise you are simply talking about lucky dice, counting cards, how to best spin the roulette wheel, the best Pai Gow dealer, or when to bet the river with three deuces.

[zero intelligence]

The "senior portfolio manager" thinks that PE holdings should get a takeover bid premium? You pay a premium for control when you buy. Once you buy it, then the only other step is to sell it. Why would this demand a premium? If anything, there should be a liquidity discount. Maybe the "senior portfolio manager" should try to IPO a PE project after the stock market has fallen 30%+ and find out what kind of "premium" he's getting.

IMO, this guy sounds like a blowhard. IRR is important but there should be some adjustment for risk, not necessarily a "mark to market" but some appreciation of liquidity and internal leverage.

[Beancounter]

  A pension fund manager needs to do to things:  1) make sure that he/she can cover the benefits promised by 2) investing in assets globally that will deliver on that promise.  

The only classes that seem to do that are alt assets, oil, timber, etc even gold, though they may not have current yield, they do deliver real return, and can be reasonably hedged.  Equities, as we have seen of late, seem to be as volatile, if not moreso.  

[Derpin USA]

I don't know much about this topic, but it's Leo.

Is it safe to assume he's wrong here too?

[JW n FL]

LOL! Solar has done well.. dont be a ha8ter!

Leo is a Bull, he deserves credit for being positive.

I will RT just for the Fun of it!