The below article has been published in Investment Officer in March 2023.
Global listed equities fell by about 25 per cent in 2022, while the global private equity market achieved only a negative return of 3 per cent. A striking contrast as both markets faced similar challenges of flattening growth, stubborn inflation and rising interest rates.
Every field has its own assumptions and theories. Within our industry, most people generally agree on the following statements:
- Investing is about consciously taking risks;
- (Some level of) diversification is wise;
- Risk and return are interconnected, and;
- “It is difficult to make predictions, especially about the future.” – Mark Twain
However, the valuation differences between private and public markets cause division among analysts. For example, publicly traded stocks worldwide dropped by about 25% in 2022, while the global private equity market only recorded a negative return of 3%. This is a striking contrast, given that both markets faced similar challenges like flattening growth, persistent inflation, and rising interest rates.
Source: Preqin Quarterly Index, observations per quarter & returns in USD
Scylla & Charybdis
In Greek mythology, Scylla was a six-headed monster that lurked in the strait between Italy and Sicily, while Charybdis was a whirlpool on the other side of the strait. Ships attempting to navigate past these dangers risked being caught by one of them. This myth illustrates the tension that private equity investors face. On the one hand, they observe moderate (perhaps unrealistic) price fluctuations in their capital statements. On the other hand, they hear Jim Cramer shouting about ‘how bad it is out there.’
The lack of the daily discipline of the market means that private equity managers largely have to value their own investments. Although valuation methodologies are somewhat standardized, managers have a lot of flexibility to stabilize their performance; the so-called ‘return smoothing’. In practice, this results in substantially lower volatility in private markets compared to public markets.
Before we can conclude whether ‘you can sleep peacefully’, the question is whether price developments in public markets are completely irrelevant. Market efficiency is a core concept for economists to describe how well available information is reflected in the valuation by Mr. Market. It is reasonable to say that market prices offer a fair price estimate for investors—aside from idiosyncratic and short-term fluctuations. Perhaps a 25% decline for private markets last year would have been excessive, but 3% might well be a navigational error towards Scylla or Charybdis. As usual, the right course is likely to be somewhere in the middle.
De Gulden Middenweg
How much private markets ‘should’ decline is, in practice, less relevant for most investors. What is more important are the consequences and remedies for a thoughtful portfolio management process. Optimists point to the benefits associated with return smoothing, such as a better long-term perspective and lower agency costs within the governance structure of institutional investors.
The downsides are less obvious but no less important. Even for investors with a long horizon, the actual risk profile of private equity is needed to construct a logical portfolio. Unfortunately, return smoothing results in standard risk measures, such as volatility and correlations, appearing disproportionately favorable compared to other asset classes. The consequence is an excessively high portfolio allocation to private equity that is not justified by underlying economic factors. The risk profile can be adjusted by incorporating statistical methods (e.g., corrections for autocorrelations and lagged beta). However, in practice, portfolio limits combined with a thoughtful and consistent allocation policy form the most logical solution.
Furthermore, the high historical returns combined with low (observed) risks have led to a significant influx of capital into private equity funds. Sceptics argue that this will put considerable pressure on the expected returns of the asset class on average. This underlines the increasing importance for investors of a careful process to select competent managers.
Conclusion
It is unlikely that financial professionals will ever agree on the correct level of price decline for private equity. Yes, return smoothing has an impact. And yes, public markets can overreact. Fortunately, the medals in private equity (i.e. carried interest) are only awarded at the finish line and the monetary hit by return smoothing to investors will be limited. In the meantime, investors should not fall prey to the downsides of return smoothing, but rather embrace its behavioural benefits. In short, identifying the golden mean between Scylla and Charybdis also offers a valuable lessen for investors in today’s world.