Private Equity: Not Diversifying, Barely “Alternative,” And Now On Thin Ice

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I have always been intrigued by how private equity ever got labeled as an “alternative investment”, let alone a “diversifying” alternative investment.

I get the core concept, and understand the attraction. One acquires shares in privately held companies through a non-public transaction, where the goal is a resale of the company to another company or cashing out through an IPO.

And there are certainly merits as an investment. PE funds offer a way to invest in private small cap companies, levering an informational edge while avoiding both the volatility and “quarterly earnings” obsession of public companies. It has also been generally profitable over recent years.

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All that said, there are some reasons - particularly at this point in time - to be cautious about relying on private equity for diversification.

This opinion (which is my own personal view and not necessarily that of my firm) is based on two things: First, evidence that PE funds, structurally, are much more reliant, and non-diversifying, to the public equities markets; second, diversifier or not, that PE funds at this point in time are not the safest place to park assets.

Little Diversification

The argument that PE is a “diversifying investment” seems to be fueled by the belief that there is an inherent reward for the illiquidity of these investments beyond other, more liquid investments (aka the “illiquidity premium”). But this is not borne out by the facts.

1. It is Long the Stock Market

Private equity is a long-only investment in equities, full stop – although perhaps on a deferred basis. This has been explored and confirmed by several researchers over the last decade.

One of the clearest confirmations of this recently came in the paper published by Commonfund CEO Mark Anson. As others have, Anson emphasized the need to address the “lag” effect when comparing private versus public securities. However Anson’s paper is unique in the level of detail in which it does so. He demonstrated, for instance, how market betas are statistically significant going back three prior quarters of market returns.

I do note that the majority of the larger PE funds have generated returns roughly full percentage point or two (net of fees) above their favorite benchmark, the S&P 500 index. When pitted against the (much more appropriate) small-cap stock indices, however, private equity funds actually are about on par, if not a few basis points below. Author Paul Davies presented a research study conducted by Cambridge Associates that showed, at best, the results were mixed at best.

2. No Safe Haven

As mentioned above, there are some appreciable differences between private equity and the traditional public equities markets. But when using the term “diversification” most investors tend to mean something that is remote from, or can even counter, the month to month cyclical ups and downs of the stock market.

But history indicates that a downturn in public equity or credit markets should and will have a dampening effect on the returns of a private equity fund.

The point of the Cambridge Associates study cited above was to simply model the relative performance of PE versus the S&P 500 index over multiple cycles and PE fund vintages. However, I noted that the results also indicated that during poorer-performing years (e.g. 2008, 2011, 2015) that PE funds typically (but not always) underperformed the S&P500 Index at a time when the index itself was, well, underperforming.

Hedge fund strategies, such as market-neutral, event-driven and relative value programs, offer diversification by generating alpha at time that can dampen the drawdowns associated with the equities markets – hopefully while also attempting to generate robust alpha.

Sadly for hedge funds, however, this greater transparency and liquidity of these types of strategies presents both a blessing and a curse. Knowing what’s going on at all times can prompt investors to make near-term (and near-sighted) decisions, versus an asset class where you can retreat into a comfort of ignorance.

3. Illiquidity Premium Worth the Illiquidity?

Let us assume for a moment that proponents of PE could somehow dispel the statistical results from the beta analyses cited above. We are still left with a diversification problem.

True diversification isn’t just being diversified on Day One; it means the ability to stay diversified – to reduce and increase allocations across different strategy buckets.

In listing the various misconceptions about private equity, I was also tempted to venture into the regulatory area. But I’ll leave that one alone for now. I will just cite that in 2016, the Center for Economic and Policy Research circulated a policy statement suggesting that the lack of transparency and regulation over the activities of private equity GPs was so lax as to border on “fraud”. The paper cited dangers for pension funds in particular, and that the Department of Labor and SEC regulation on PE funds was so relaxed that the authors even implicated these regulators as unwitting accomplices.

I conclude this part of my argument with a request to the industry: Please just stop calling private equity “alternative” or “diversifying” simply because you cannot see it or get out of it.

Even if PE Does Diversify, Is it a Good Investment Now?

According to Ernest Young’s Global PE Watch in July 2017, private equity assets were estimated at (an all-time high of) $2.83 Trillion, with $453 Billion of that raised by 921 funds closed that year alone. Regardless of whether a reader agrees or disagrees with my “no diversification” argument above, let’s take a look at this asset class purely on its merits as an investment in the current environment.

1. High Multiples. Institutional investors apparently are not bothered by oddball, seemingly random, EBITDA figures (and P/E ratios) for private companies. Just before the financial crisis, in 2007, the average purchase price for a PE deal was around 8x or 9x EBITDA. According to S&P Capital IQ, after a significant dip prices reached 8.8x again in 2013, but have now surpassed any pre-crisis level, climbing to an average of 11.4x EBITDA as of the end of last year.

2. High Multiples, Now Add Leverage. Now couple leverage risk with insupportably high multiples and the picture gets a bit scary. Investment pundits have often notes how investors seem to not ask about leverage when it comes to private equity. The average private deal today is roughly two-thirds debt financed. The leverage may not be at the PE fund level itself, like a hedge fund, but the companies they invest in certainly do indeed take it on.

During the market drop of 2008, for example, the S&P 500 index tumbled -34% while several well-known private equity funds priced their books at year-end down -50% or more (if they were honest and transparent in their marks). In 2009, as the S&P 500 bounced back by +20%, these same funds soared upward by +35% to 50%.

While this doesn’t sound like a bad thing, a change in, or acceleration of, U.S. interest rate policy could come with chilling consequences for private market participants.

Some may be getting spooked already. According to Pitchbook’s 2017 4Q report, there’s been a decline in the number of deals closed and exit activity despite record fundraising and more than half-a-trillion in dry powder. And with a higher cost of debt potentially on the horizon, activity could slow even further in 2018.

3. When I Can’t See the Risk that Must Mean It’s Not There. This is an asset class that features 7- to 10-year lock ups, and very little transparency in the interim. And yet we often we hear sophisticated, institutional investors say that PE is “much less risky” than hedge funds.

So why aren’t the high betas, high multiples and leverage inherent in PE enough to at least consider using the R-word? Most likely due to overly-smoothed accounting. Where the valuations of public equities are determined by transparent, liquid public markets, PE funds determine the valuations of their own portfolio companies. So, it’s not a shocker that they report far lower volatility than public markets.

The smoothing effect of this “appraisal”-based accounting is also what recently led the CIO of the Public Employee Retirement System of Idaho to draw attention to the “phony happiness” of private equity. The startling thing is that the CIO did not intend this as a criticism. As of the start of 2018, it was reported that Idaho actually increased its allocation to the asset class.

A growing number of academics and economists are much less sanguine. A leading finance professor at Washington University published a paper cautioning portfolio managers to resist the ”incentives to obfuscate systematic risk and to choose investments that appear low-risk.”

Market pricing demonstrates that private equity is far riskier than internal valuation marks suggest. For this the secondary markets are informative. In the depths of the financial crisis, for example, PE secondary buyers were able to easily pick up many funds at around 50 percent of their official net asset value (NAV) at the time, something that you don’t see often outside of emerging market bonds. Perhaps this illustrates just how far away the official NAV is from actual value.

This “appraisal”-based accounting, in turn, feeds back into the leverage problem. How? Smooth numbers don’t just encourage investors to take the plunge (I tackle that one next, below), but lenders as well. After the financial crisis, the Federal Reserve warned banks not to allow their corporate clients to take on debt above 6x EBITDA.

Lenders have generally complied with this, but PE firms play with the definition of “EBITDA.” Whereas regulators require public companies to use GAAP financials, lenders allow PE firms to remove certain cost items to get to a “pro forma” EBITDA and/or take a recently profitable period and extrapolate from that period to an optimistic, longer-term “run-rate” estimate.

Lenders are allowed to accept these estimates and, in some cases, even further pro forma these themselves. This is something a manager of any liquid hedge fund could only dream of doing, but would be immediate shut down and probably indicted if they tried.

But is all this smoothing so bad if everything comes out right in the end? Is it a federal crime to reduce some of the erratic zig-zags along the way? Not in private equity, but it is in most other investment instruments. Seeing nice smooth lines rather than those nasty wiggles exhibited in other markets only attracts more buyers, and more buyers mean even higher multiples. And, as AQR principal Antti Ilmanen has openly asked, maybe a big reason for the relatively higher fees associated with PE is that buyers are willing to pay up for this smoothing.

4. Are the Returns Enough to Compensate for Illiquidity? Earlier in this article I cited the general observation that most of the large PE funds barely broke the small cap benchmark returns when stretched over time. So is this enough to accept the long-term illiquidity of a PE investment?

Some may counter that these figures are either unfair or cherry-picked. Okay. So let’s assume that the average large PE fund returns about 2% per annum over whatever favorably chosen index is used. Does this do the trick?

In 2016 Willis Towers Watson dedicated a report to the issue of the illiquidity risk premium (or “IRP”) of various illiquid asset classes. Roughly halfway through the paper, the authors confess that they purposely left private equity out of the analysis. They found it overly complicated and largely useless to try to determine the IRP for this asset class. The authors conclude: “. . . . whilst we suspect private equity does provide an IRP to some degree, it is onerous to disentangle it from the control, skill and other risk premia that drive the additional expected returns of private equity over its [publicly] listed siblings.”

My translation of WTW’s very kind comment: As there’s little basis for measuring the illiquidity premium, just invest in publicly listed – and liquid – small-cap stocks.

5. Transparency by a Different Standard. PE funds generally will not offer any day to day (or, sometimes, even month to month) returns – that’s a given. But what about disclosure of costs and other deal terms?

Most fund GPs still offer performance fee information only to their largest LPs, typically institutional investors. But even in these cases they bind the institutional investors to non-disclosure agreements that prevent them from sharing with their constituents. When it comes to hedge funds, on the other hand, pension sponsors typically pass on this information to their beneficiaries in their periodic reports and meeting minutes.

Conclusion

I welcome other opinions on what I’ve cited above, and am happy to be corrected where I am wrong. I will concede that “PE” today is not the PE of 10 years ago. There is greater transparency, more discipline, new types of deals (e.g. strategic partners), and more watchful eyes. One has to be careful not to tar all deals with the same brush. I only hope that the lessons learned from the overpriced and overleveraged deals struck back in the rage of the last cycle are not forgotten. It is too early to tell whether today’s structural differences will lead to PE weathering economic and market cycles better than in the past.

All I ask of investors is that, assuming the bulk of my observations here are valid, they raise these questions before embracing private equity as a diversifying “alternative investment.”

Different investors have different incentives. Institutional investors probably understand these risks more than others, and have access to the higher quality deals, and the negotiating power to get terms that make credible sense. But some commenters have cited more cynical reasons – including portfolio managers’ temptation toward good optics on returns for the next eight years.

Wealth advisors and RIA have also been selling private equity investments to individual clients in increasing numbers. This is also increasingly attracting critics. One popular blogger – a self-described “reformed” RIA himself - offered one explanation: The ability of RIAs to tell their clients they’re “part of the club. ” Just being able to mention “private equity” to ones client conjures images of exotic retreats on Lear jets. The blogger warns investors that in many cases the PE funds their advisor presents to are really the investment equivalent of Wolfgang Puck restaurants: They “made their reputations decades ago, now available in mall food courts, airport terminals and theme park snack bars everywhere . . .. But it’s still Wolfgang Puck!”

Article by By Jon L. Stein, CEO, Kettera Strategies



About the Author

Jon L. Stein
Mr. Stein has 27 years of financial industry experience with a focus on portfolio management and managed futures, FX, and commodities’ strategies. Jon has been a Managing Director, Founding Partner, and Chief Investment Officer of Efficient Capital Management, and managed other platforms. Mr. Stein is the author of Trading Currency Cross Rates, published by John Wiley & Sons in 1993. He holds a BS from the University of Wisconsin, Madison and a JD from Chicago Kent College of Law.