Below is an excerpt of our interview with Seb Canderle, which can be seen in full on ValueWalk Premium. In this part, we ask Seb if private equity can be replicated in the public markets.
Raul Panganiban: Wooah, and then just want to know if you are familiar with Verdad. They publish research on using factors to replicate private equity in the public markets such as leverage and small equity. Do you think that private equity can be replicated in the public markets?
Seb Canderle: Well, I am aware of Verdad. Although I am not familiar with the details behind their investment approach, to some extent I agree with their general philosophy that private equity techniques can be replicated to invest in public markets. I worked for four fund managers, including The Carlyle Group. I believe that one of the founders of Verdad worked at Bain Capital before setting up his business.
There is no magic behind private equity techniques and, contrary to what they say to their investors, executives at the large PE firms do not have any unique model to invest and monitor portfolio assets. They all have the same skills, they are all ex-bankers or consultants, they all have MBAs or accountancy qualifications. As I said before, they are deal junkies, or deal merchants I think is the term I used.
So investors who spend a lot of efforts doing due diligence to select the best fund managers are only kidding themselves. Research has shown that there is little persistence in PE. A top-quartile fund manager is extremely unlikely to remain so vintage after vintage. Eventually, top performers revert to the mean. So it is very easy to replicate their techniques for public markets. But the biggest challenge is to introduce consistency in performance.
I mentioned that my first employer in this sector was that pan-European LBO firm Candover. It was top-quartile for its 1994 vintage and bottom quartile for the 2005 Fund. Its 2008 Fund performance was so bad that the firm has since been liquidated. There is a long list of zombie funds that never raised another vintage after the global financial crisis. I can safely predict that the same will occur when the next economic recession takes place.
The concern with applying PE practices to public markets is the problem of volatility. The main reason why we do not see many PE fund managers collapse is because their investors cannot force redemption, unlike what happens in hedge funds for example.
Again, I do not know enough about Verdad to understand how they deal with this liquidity risk, but the danger is that in a downturn, investors will pull out of public equity, which will greatly impact Verdad’s underlying portfolio valuations.
Bear in mind that most PE fund managers do not properly mark to market, which is why they are said to offer low correlation to public markets. It is in my view an illusion, as when public comparables fall in valuation, private assets should fall in proportion, but that lack of mark to market is one of the many tricks used by PE firms.
In any case, public asset revaluation could lead Verdad’s lenders to call in their loans - if they are worried that the underlying assets no longer cover debt obligations. That might create a liquidity crisis. I don’t know how Verdad has addressed this risk - probably by signing LP agreements and loan agreements that protect them against this kind of overreaction that is so common in public markets.
Alright and then you recently published the last of your trilogy, The good, the bad, and the ugly of private equity. What was your main objective with all three books? And can you provide me an overview of what you were trying to accomplish and how each book fits in the overall objective?
Seb Canderle: Sure. I guess the most basic reason for writing these books was educational. When I started in PE in the early noughties, there wasn’t a single book explaining the practices to carry out buyouts. At the time, I remember struggling to make sense of what we were trying to accomplish.
The only book you could find was Barbarians at The Gate. You probably heard of it, it’s an entertaining but useless narrative of KKR’s buyout of RJR Nabisco. It was a journalistic piece that did not help any practitioner learn the tricks of the trade.
So my books aim to help financiers and corporate executives understand LBOs better.
See the full transcript on the topic of private equity can be replicated in the public markets and much more right here